Michael Kelly

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MORTGAGES EXPOSED
Author: Michael Kelly
A mortgage is probably the largest financial transaction in the lives of
most people it pays to know more about it and how to profit from it.
Mortgages Exposed is written by an acknowledged expert with over
thirty years experience in the mortgage business.
The book delves into the innermost parts of mortgages and loans,
explaining how they really work starting from the first principles of
compound interest, describing the use of powerful comparative tools
such as the Internal Rate of Return and the magic of gearing.
The target audience is the more discerning borrower, as well as for
anyone involved in the financial services industry. The book focuses
on thinking from first principles, and so it should never date.
Free, general-purpose spreadsheets are included on the attached disk
(or for download on the web site): easy to use that you can become an
instant mortgage expert, able to analyse many different scenarios and
get immediate answers to all your what if questions.
Anomalies are exposed, the infamous Rule of 78, the flat rate loan and
the lenders who calculate payments in bizarre ways. The new rules
(as from April 2000) for APR calculations are explained.
The endowment mortgage scandal is explained and analysed. A clear
answer is given to the dilemma over whether to choose interest-only or
capital repayment.
Use the complete, general-purpose guide on how to choose any
mortgage scheme from the thousands of available options.
Flexible and Current Account mortgages are specifically looked at.
Michael Kelly first launched these schemes as early as 1979.
Kelly also goes into some detail on the advantages and risks of buy-to-
let, and explains how to gear up your profits by several multiples.
A section on how to become a millionaire will excite the entrepreneur
wishing to exploit mortgages to create wealth.
What is the lenders view? Lenders and mortgage brokers will find the
spreadsheets for designing a mortgage very useful to ensure the right
returns are achieved.
Equity release schemes of all descriptions are outlined together with
the novel Reverse Mortgage scheme for the house rich but cash poor.
The epilogue summarises the story and attempts to analyse the future
of digital loans & mortgages.
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Preface
Author Michael Kelly and his wife Dee were directors of software company
Dunstan Thomas Limited for the last six years of the 20th century and both
contributed much to our success as computer software pioneers. Their son
Robert remains on the board and has inherited his fathers skills in the
mortgage business so we can continue to serve our growing band of financial
services clients.
Dunstan Thomas is delighted to sponsor this book by hosting it as a web site.
Michael Kelly has never intended to profit from its publication. As a champion
of the consumer, he is more interested in seeing his message promoted both
to the public at large and to fellow professionals in the mortgage industry
where he worked for some thirty years. The Prologue summarises some of
the key events in his remarkable business life.
As you will see as you read on, Michael is a great exponent of spreadsheets
and he has designed a number of quite amazing mortgage and loan tools for
borrowers, brokers and lenders, all of which are freely available for
downloading on this web site.
For our part, we can design full-scale software applications for any financial
service operation, which can be directly tailored to specific business needs,
particularly when related to e-commerce.
This book is not for the faint-hearted: there is some mathematics lurking
about, but Michael does make it as easy as possible to grasp important
principles such as the Internal Rate of Return, so we commend your
perseverance. Your reward comes in Part II, particularly the sections on
gearing and how to make a million indeed if you read those sections alone
you could be repaid the time spent many times over.
Astute laypersons will also find much to delight them, even if they download
just one spreadsheet on how to choose a mortgage the Mortgage Scheme
Select Wizard. The authors logical approach and his focus on principles,
rather than just transient contemporary wisdom, ensures that the reader picks
up some skills for life, as opposed to assisting a specific mortgage or loan
transaction.
The book is also available as a printed manuscript, but we ask for a price of
10 to cover printing, materials and postage.
Chris Read
Chairman
Dunstan Thomas Limited
www.dthomas.co.uk
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Mortgages Exposed Amended Aug 06
Contents Page Number
Preface 5
Prologue who this book is for and by 9
Introduction 14
Part I The Theory
Fundamentals of compound interest
Simple interest 15
Compound interest 16
True rate 16
Nominal rate 19
Capital repayment loans 20
Flat rate loans & the Rule of 78 22
Using Spreadsheets 24
Building Society mortgage trap 25
Glossary so far 28
Comprehension check 29
Internal Rate of Return 31
Annual Percentage Rate 33
Net Present Value 35
The Technical bits and formulae 39
Part II The Practice
How to choose a scheme and how to profit from mortgages
Introduction 50
Pricing a feeling and separating the logic 51
Some more basic definitions 52
Why buy a house and not rent? 56
The future of house prices 59
Preliminary rules for choosing a scheme 61
Interest-only or repayment mortgage 63
The endowment mortgage scandal 64
Comparing the costs of interest-only mortgages 64
Investment choice depends on attitude to risk 66
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Contents continued Page Number
Conservative investments no good for mortgages 67
The past is no guide to the future 68
Do you have an under performing endowment 71
Mortgage products 75
Cashback & Discounts 76
Fixed rates 77
Flexible mortgages 79
Current account mortgages 83
Special loans 84
General features of lenders 86
How to select a mortgage scheme summary 87
Buy-to-Let and the magic of gearing 94
How to become a millionaire 99
From the lenders perspective product design 104
Equity release and home income plans 106
Annuities 107
Shared appreciation and reverse mortgages 109
Epilogue the Internet the future 115
Annexures
A: Low start, flexible payments & index-linking 119
B: Current mortgage regulation, the Code, & CATs 123
C: Largest thirty mortgage lenders 128
D: Spreadsheet Summary 130
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Van Roys Law: Honesty is the best policy theres less competition.
Prologue - who is this book for?
Any expos of mortgages might hint at dark secrets implicating our largest
institutions in dirty deeds. While there are indeed secrets and surprises, most
of the news is good, apart from just a few naughties: for instance, the so-
called endowment mortgage scandal is analysed. Some readers may want to
jump immediately to the section on How to be a Millionaire but it will
probably pay to be patient, and work up to it.
The principal aim of this compendium is to get into the basic structure of a
loan or a mortgage, and explain how they are designed, costed and
calculated. What are the hidden costs, if any, and what is their relevance?
How should a borrower select just one product from the thousands offered by
some one hundred different lenders? What really is a "best buy"? When is it
worthwhile switching from one scheme to another?
The book does not set out to be a popularist treatment of mortgages. Rather,
it aims to present readers with all the necessary tools and thought processes
to enable them to come to their own, logical conclusions. It attempts to
explain basic principles and facts rather than offer opinions and list opaque
empirical rules, and focuses on those facts that are most often misinterpreted.
It might seem complex in parts to some readers, yet over simple to others. It
also dwells on a few novel concepts.
Mathematics is involved, but the formulae used to perform almost any
calculation involving mortgages or loans is explained as simply as possible.
Readers need no profound knowledge of mathematics, beyond a good level
of numeracy to secondary school level. The purpose is to impart a better
understanding of the generic anatomy of any loan as a financial product.
Access to a spreadsheet programme such as Excel or Lotus 123 is helpful,
since a useful range of easy-to-use spreadsheets is included on a disk or, for
web readers, as a free download. These sheets are designed to answer most
of the important mortgage and loan questions without the need for any special
spreadsheet knowledge.
The full power and sophistication offered by some more advanced
mathematical methods is also included for completeness but not for
necessity. Anyone professionally involved in the mortgage and loans
business will hopefully find something of value. Borrowers with enquiring
minds may find much to enlighten them. Technical terms are explained and
the more complex parts are consolidated into a separate section called
Technical bits in Part I, to insulate the merely curious from the technicians.
Computer programmers may find some of the formulae discussed here to be
useful for their work.
Innovation
The fierce rivalry in the mortgage & loans business persists. Contemporary
money supply mechanisms have ensured there is more cash available to lend
than there are people wishing to borrow. As a result of this oversupply,
lenders are constantly experimenting with innovative products to attract an
increasingly discerning and Internet-aware consumer. The classic endowment
mortgage has already fallen from grace and we will look at the pros and cons
of this long running dilemma in more detail.
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Today's loan products are far more sophisticated than ever before. Flexible
payments, cashbacks, discounts, fixed rates, low starts, impaired credit, non-
status, buy-to-let, shared appreciation, index linked, LIBOR linked and many
more ideas go and come and occasionally reappear.
The Internet now provides a business channel that demands far closer
attention to real value for money as well as comparing all the other key
attributes of a well-designed mortgage or loan product. Mass customisation is
now easy to automate on the World Wide Web. Never before has it been so
essential to understand the numbers behind the numbers.
So what is the best deal for the borrower? What product is more attractive for
the lender? How are the monthly payments calculated? What is the
redemption amount? What is the Rule of 78? Is a re-mortgage worthwhile?
What is the best product for an individual and is the new APR effective for this
purpose? Is it worth borrowing to buy a rented property? What is gearing? Is
it worth borrowing at all?
For the answers, read on. Check the disk that comes with the book, which
not only replicates this text, but also provides practical, dynamic examples of
the maths in action in simple spreadsheet format, so all your personal what
if questions are handled instantly. The whole treatise is available for
downloading on www.mortgagesExposed.com including the spreadsheets.
Why me?
From an early age I have always been fascinated with mathematics. The
logic and preciseness of the essential thought processes were particularly
comforting to an adolescent, trying to come to terms with a greater world,
which seemed anything but logical.
But it was especially delightful to discover later on that maths could be such
an intrinsically practical activity. It was possible to define real life situations
using mathematical formulae with a precision that could even take account of
the vagaries and unpredictability of real life.
For example, the life insurance actuary possesses the skill to define a human
life span in terms of formulae on which a whole industry depends. Nothing is
less predictable than your own date of death, but when an actuary takes the
human tribe as a group, he would literally gamble his bonus on getting life
expectancy "dead" right. This rudimentary, but magical expertise is the
fundamental basis of the huge life insurance industry.
In the mid sixties, I was a twenty something year old Army officer with a
Cambridge University degree in Engineering, but otherwise pretty unworldly.
My wife and I were content with renting our modest, comfortable and
subsidised Army quarter, especially as we paid neither interest to a lender nor
premiums to an insurance company. I remember arguing with some equally
naive insurance broker who was determined to sell me an endowment policy
in preparation for a future mortgage.
Whilst this broker was very insistent that the endowment mortgage was the
right stuff, my freshly educated mind was then expecting a simple
mathematical proof, which he was not able to present. By then my whetted
appetite demanded more knowledge. Eventually another broker convinced
me to buy a house, and a life insurance policy, using a series of simple
mathematical arguments that seemed stunningly conclusive.
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I was so struck by the logical deductions in the sale process that I declared
there and then that I wanted to leave the Army, buy a house (with the largest,
longest, cheapest mortgage I could get) and then become a mortgage
consultant and spread the gospel. This was in the late sixties, when most of
my colleagues in the Services thought renting was the right thing to do. I was
aching to convince them that there was a better alternative.
In those young, innocent days, my nave excitement was almost like a
missionary calling. I wanted to share my ingenuous, St.Paul-like conversion
to the concept of house-purchase-by-mortgage with the entire world.
It was some years later when I realised that the successful early sales I had
achieved was more to do with my rather transparent enthusiasm and not, as I
then believed, the high minded logic that I had pompously considered as
being so persuasive. My early clients, colleagues and friends, later confided
that they actually had little idea what I was actually talking about from my
initial sales patter. But they did admit to being caught up with my own zeal to
the extent that they thought I must be "on to something" and so they bought
my passionate story. I give thanks to those early, tolerant disciples, who
luckily prospered from the housing market they were encouraged to enter.
I spent the first half of the seventies as a mortgage broker, and the second
half dealing with more general financial planning and investments. I
combined the two in 1979 by launching the first ever index-linked investment
product (linked to the RPI or Retail Prices Index), which was underpinned by
my concept of a residential index-linked mortgage. Our new company was
initially named ILMI which rather cumbersomely stood for the Index Linked
Mortgage and Investment Company Limited.
Despite double-digit inflation, and before index-linked gilts were invented, the
mortgage product proved more attractive than the investment, which then
lacked the credibility of a brand name. Merchant bankers, Lazards, were later
persuaded to sponsor the first RPI index-linked unit trust. Skandia Life also
launched the first RPI linked pension fund. Both schemes used my index-
linked mortgage concept, which ILMI both marketed and administered. The
mortgage product is explained in more detail in Annex A.
The principal attraction of the index-linked mortgage was the low start. The
initial monthly payment was around 30% lower than a "normal" mortgage and
future payments were guaranteed to remain the same in "real" terms
throughout the term, in other words, the true purchasing power was constant
throughout the term.
The low initial payments permitted people to afford larger loans. In a decade
when house prices moved only upwards, this method of loan also promised
greater profits to the borrower. Falling house prices would (and did later) have
the opposite effect.
The eighties proved to be a particularly exciting decade for the mortgage
business that was then at its most innovative. The low start payment method
was refined to attract conventional funding. Mortgage Systems Limited was
born out of ILMI in 1981 to exploit the demand for a new style low start,
flexible payment mortgage. The Thatcher years were more about investing
than nesting, and the house purchase business was then booming. Mortgage
products, particularly those that enabled you to obtain a larger mortgage for a
lower cost, were in great demand. Mortgage Systems obliged by designing,
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marketing and processing applications for a whole range of low start, flexible
payment mortgages for its many lenders, and we then provided an on-going
mortgage administration service.
Adrian Bloomfield, the well-connected entrepreneur then running second
mortgage lender Premier Portfolio, introduced me to John Gunns British &
Commonwealth, a company determined to be a major force in financial
services. They showed an interest in our still quite fledgling company. When
we finally sold Mortgage Systems to British & Commonwealth in 1989 (who
later went into administration and were forced to sell our old company on to
the Skipton Building Society, who renamed it Homeloans Management Ltd),
our 600 dedicated staff were managing over 3.5 billion of mortgages for
around 20 worldwide institutions, occasionally processing over 2,000 new
applications per week. But although now my main business passion had
been sold, I was not yet quite ready for retirement.
1990s
I joined the board of Mortgage Group Holdings, which then owned UKs most
popular mortgage broker, John Charcol, ably led by its clever founders,
Johnny Garfield and Charles Wishart. I was already a non-executive director
of Private Label Mortgage Services Limited, the hugely successful mortgage
design and marketing operation run by the ebullient Stephen Knight.
Stephen & I attempted to launch a reverse mortgage scheme by founding a
company called Home Income Trust PLC, with a product designed for asset
rich, but cash poor, homeowners. But this turned out to be incredibly badly
timed. House prices started to move downwards and some well-publicised
scandals surrounding home income schemes frightened off both potential
customers and their lawyers. Soon the publics confidence in these plans all
but collapsed so we withdrew the product and mothballed the company to
wait for better times. The scheme still has merit, and is described herein.
A spell first as a consultant and then as a director of The Paragon Group in
the late nineties (Paragon was previously NHL - National Home Loans -
another company founded out of the exuberant mortgage market in the mid
eighties) enabled me to experience for the first time life as a wholesale
lender. NHL had expanded fast in the eighties. It was sales led, and it sold
just about everything demanded by borrowers and mortgage brokers alike.
Unfortunately the subsequent house market collapse in 1990 left NHL
exposed to the less reliable borrower, and massive arrears almost sunk the
company. In the early nineties, a new and very able team of Directors
gradually put the company back on its feet and the share price rebounded.
Home Loans Direct was first formed to restart our lending programme (this
was my new role) and now, as the renamed Paragon Group, we have
successfully expanded, by both acquisition and organic growth, into other
niches and consumer loan activities.
To lighten our load, my wife and I disposed of our interest in e-commerce &
software specialists Dunstan Thomas Limited in May 2000 and resigned our
directorships. With just a property investment company and a debt
management company left, I am now sort of retired well, shall I say in a
reflective phase, but my early passion for the science of mortgage design still
thrives. Consequently, while my recall system is still just able to function, I felt
I wanted to set down and distil some of those early, but still valid, logical
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arguments in a more generic and understandable way and relate them to
today's faster moving digital world.
So now, here we are with a book that is more about the numbers behind the
scenes rather than the art of marketing mortgages. I hope I have made it
interesting enough to encourage the reader to start using the spreadsheets
included that are general purpose enough to be really practical, and the on-
line tools on the web site.
I remember a well-known parable. If a man is starving, dont just give him a
fish, as this might only feed him for one day. Instead, give him a fishing rod,
and show him how to use it, so he can then eat every day. I am attempting to
offer you, dear reader, a fishing rod plus some instructions. Hopefully you will
then be able to apply the techniques described here to fish for a better loan
product, and encourage others to do the same.
June 2000
- oOo -
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Introduction
Mort is a French word meaning dead. A mortgage is better known as a loan
secured by land or property, although sounding like a mortuary and indeed
some people might contemplate murdering their mortgage lender. More
precisely, a mortgage is actually a legal document, but one amortises a loan,
which means paying it off over an agreed schedule and thereby killing it.
In fact, the only distinction between a normal loan and a mortgage, is that
mortgage lenders have a house they can legally sell in the event of the
borrower not paying as scheduled. Some loans are secured with other
assets, such as cars or washing machines, stocks or shares. Some loans are
unsecured. But the basic structure and mechanics of the loan is the same
whether it is secured or not.
The three essential variables describing any loan or mortgage are: -
1. The initial capital sum or principal that is to be lent.
2. The interest rate which sets the amount of interest to be charged on
outstanding capital and when it is charged. The interest rate may
vary.
3. A repayment schedule laying out how the interest and capital is to
be repaid.
As far as item 3 is concerned, there are an infinite number of repayment
variations but the two main types of schedule are: -
(i) Capital repayment loans, where capital is repaid gradually
throughout the loan term as part of a regular payment,
(ii) Interest-only loans, where only interest is paid during the term, and
the amount owing settled at the end with a lump sum. This sum
usually arises from selling a separate asset. An endowment
mortgage aims to use the proceeds of a maturing endowment
policy to repay the debt, but more often it is the sale of a house that
settles the mortgage.
While interest-only loans are very straightforward from the lenders
viewpoint, their overall value-for-money for the borrower depends
totally on the performance of the separate repayment vehicle.
A loan to a borrower is an investment to the lender. The interest paid by the
borrower is an investment return to the lender. So the formulae used to
calculate a loan schedule are practically identical to those applying to an
investment. Fees and costs will affect the overall return to the investor and
will also add to the final burden for the borrower. But fundamentally the
mathematics is the same for the borrower and the lender.
Compound interest can be an elusive subject. There is no known simple,
single formula that can be used to calculate true interest rate, given a
repayment schedule: so comparing loan schemes has never been an easy
task. Fortunately, there is an excellent method available and the more
prevalent use of spreadsheets has greatly simplified its application. If this
book sheds light on this process alone, it may have been all worthwhile.
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Termans law: Education is what you get from reading the small print. Experience is what you
get from not reading it
PART 1 The Theory
Please dont be frightened off this initial part as possibly being too technical -
it is not as mathematical as you think. It is important to understand the shape
and feel of the figures illustrated in the various tables. It is not necessary to
test every line, unless you are a real enthusiast. I have included the more
technical bits in a separate section at the end of Part I, so its all there if you
wish to indulge in the full magic of the maths, and of course the figures
reappear in the spreadsheets together with the formulae used.
Simple and Compound interest - the fundamentals
Banking may not be the oldest profession but it was probably started by
demand from the oldest profession. There are people who have money and
those who need it. Depositors or investors want a safe return on their capital,
and businessmen and others want to raise capital for a variety of reasons.
The bank was the earliest go-between, passing back to their depositors most
of the interest they charge their borrowers, naturally retaining a modest
margin for themselves. Building Societies were formed later on as mutual
non-profit making businesses to focus on straightforward savings and the
provision of mortgages.
These Institutions created the need for some basic mathematics to enable
them to maintain a fair and consistent standard for rewarding investors and
charging borrowers. They had to have some simple formulae to calculate
interest over time. The phrase Time is Money is an exact science as far as
banks are concerned, as time is the essential ingredient of interest.
You were probably taught that there are two ways of calculating interest,
simple, and the more prevalent compound interest. Simple interest is really
just a simple way of calculating interest. The method used to calculate it is
actually quite inaccurate but it was fashionable before computers enabled
more complex and more exact calculations to be performed. The use of
simple interest as a measuring tool is quite ineffective in most cases and
certainly is of no value for comparing todays sophisticated financial products.
Compound interest is the only mathematically correct method for measuring
and comparing loan products. It is undoubtedly more fascinating but it
demands more than a superficial understanding and it does require more
thoughtful mathematical processes.
Simple interest - ignores capitalised interest
If you borrow 1,000 at 12% per annum simple interest without paying back
any capital, the interest is 120 at the end of each and every year - twelve
hundredths of the capital invested. Simple interest ignores the fact that
interest can itself attract interest. See Figure 1 for an easy illustration.
I have used the term principal to identify the initial cash that starts any
financial transaction. 1,000 is the principle in this example. Whilst this is
probably an old-fashioned word, it distinguishes itself from future capital
within any transaction sequence, which thereafter is simply referred to as
Capital. These days you will more often hear the words present value instead
of principal and future value as future capital.
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Figure 1
Simple interest example over three years
1,000 growing @ 12% per annum simple, with no
repayments.
Interest
added
Amount
owing
Notes
Principal 1,000 Starting capital
End of year 1 120 1,120 12% of 1,000
End of year 2 120 1,240 12% of 1,000
End of year 3 120 1,360 12% of 1,000
Simple interest is calculated on the principal only. The total interest
added over 3 years is 3 times 120 = 360.
Compound interest
If the interest earned is not paid out, it is added on to the capital owing. But
there becomes a time when interest should be calculated on the new,
increased capital, which then includes previous interest. Compound interest
therefore recognises that interest is capitalised after a preset period. Future
interest is then charged on the new, higher capital for the next period.
If this is repeated, with no capital repayments, the capital will grow more and
more quickly. In short, the interest increases because the capital on which it
is charged increases, which then increases future interest even more.
Interest is then compounding as illustrated in Figure 2.
Figure 2
Compound interest example over three years
1,000 growing @ 12% per annum compounding annually, with no
repayments.
Interest
added
Capital
owing
Notes
Principal 1,000
Starting
Capital
End of year 1 120.00 1,120.00
Add 12% of
1,000
End of year 2 134.40 1,254.40
Add 12% of
1,120
End of year 3 150.53 1,404.93
Add 12% of
1,254.40
Interest is added to the capital owing at the previous year-end, so it is
capitalised. The following years interest is then charged on the higher capital
amount owing at each year-end. The total interest charged is 404.93,
significantly more than the 360 shown in Figure 1.
The longer the compounding period, the more dramatic is the effect. Over
100 years for example, an initial 1,000 at the same 12% interest rate would
grow to over 83 million. Without compounding it would worth just
13,000. Clearly, given sufficient time, compound interest can have a
surprisingly large outcome: simple interest is totally inappropriate.
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Compounding frequency
When describing an interest rate you need to define the time period for when
interest is capitalised or compounded. This vital second ingredient is called
by various different names. Sometimes we simply refer to the total number
Figure 3
Compounding monthly instead of annually
1,000 invested (or borrowed) @ 1% per month interest, compounding monthly
with no repayments.
Interest Capital Notes
Principal 1,000.00
Starting
capital
End of month 1 10.00 1,010.00
Add 1% of
1,000
End of month 2 10.10 1,020.10
Add 1% of
1,010.00
End of month 3 10.20 1,030.30
Add 1% of
1,020.10
End of month 4 10.30 1,040.60
Add 1% of
1,030.30
End of month 5 10.41 1,051.01
Add 1% of
1,040.60
End of month 6 10.51 1,061.52
Add 1% of
1,051.01
End of month 7 10.62 1,072.14
Add 1% of
1,061.52
End of month 8 10.72 1,082.86
Add 1% of
1,072.14
End of month 9 10.83 1,093.69
Add 1% of
1,082.86
End of month 10 10.94 1,104.62
Add 1% of
1,093.69
End of month 11 11.05 1,115.67
Add 1% of
1,104.67
End of Month 12 11.16 1,126.83
Add 1% of
1,115.67
After 12 months the principal has increased by 126.83, which is 12.683% in one
year. With annual compounding it would have increased by only 120 or 12%.
of periods but we need to know the compounding time interval monthly,
quarterly, yearly and so on. Technically we are referring to the compounding
frequency, sometimes called accrual rate, or more often, the number of rests
per annum.
For example, instead of paying 12% per annum, lets see what happens to
our typical 1,000 principal if interest is compounded at 1% per month a
twelfth of 12%. The table in Figure 3 shows that after 1 year (12 monthly
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periods) the end result, or future capital, is 1,126.83 as opposed to just
1,120 with the annual rests used in Figure 2.
True Rate
We can now see from these figures that a rate of 1% per month produces the
same end result as a rate of 12.683% per annum not 12%. We can
therefore say that the equivalent interest rate expressed per annum is
12.683% pa. This is called the true annual rate of interest and is exactly
equivalent to saying the true monthly rate is 1%.
If we continue compounding over three years, the end result would be as
follows:-
End of year 1 1.126.83 (as in Figure 3)
End of year 2 1,269.73
End of year 3 1,430.77
I know I promised to avoid too much maths apart from a special section, but
the following bit is quite fundamental and I cannot resist telling you about it
now.
The basic formula used to calculate the figures shown above is quite simple
and is this: -
Future Value = Present Value x (1 + i)
n
where the superscripted n means to the power of. In other words we
multiply (1 + i) by itself n times. i is the fractional interest rate and n is the
number of time periods.
So the future value after 36 months is: -
1,000 x (1 + 1%)
36
= 1,000 x 1.01
36
= 1,430.77
Instead of calculating 1% for 36 months, the same result can also be
calculated as 12.683% per year for 3 years: -
1,000 x (1 + 12.683%)
3
= 1,430,77
Either way the result is the same. But using the annual rate requires fewer
calculations, once you know what the true annual rate is.
In short compounding the true annual rate over three years produces the
same answer as compounding the monthly rate over thirty-six months.
The magic term which pops up in all compound interest computations is
(1 + i)
n
. Not all pocket calculators can do this with one key press. But you
can work it out by simply repeating the multiplication of (1 + i) n times.
Nominal Rate - is not true
Whilst it is tempting to say 1% per month is the same as 12% per annum,
clearly it is not true. However lenders do use the term Nominal rate. 12% pa
nominal can mean 1% per month provided it is stated as such. It could
equally mean 3% compounded quarterly. The effect of more frequent
compounding is higher overall interest, so we need to know more than just a
rate. Whilst financial Institutions often quote a nominal interest rate, without
knowing the compounding frequency, it means very little.
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So a correctly defined interest rate must also indicate the compounding
frequency or the number of rests per annum. 12% per annum nominal,
compounding monthly (ie twelve rests per annum) means 1% per month true
and is mathematically equivalent to 12.683% per annum true. Since the true
rate is always more than the nominal rate, lenders are naturally more likely to
talk about nominal rates. The nominal rate is more likely to be a nice round
number, so it is convenient to just say 12% pa nominal payable monthly.
Lenders are seldom precise about this. In short, be sure you know just what
it means when an interest rate is quoted. Why do we want to know the true
annual rate? Why is it so important? The practical answer is for comparison
purposes. We need a consistent standard to compare all loans, regardless of
their compounding frequency. Quoting true rates on an annual basis is the
most familiar standard and common usage has made it prevalent. The later
section on Technical Bits provides more details about the mathematics.
The importance of the compounding frequency
Interest can compound at many other frequencies as well as monthly. The
Nominal rate used in all of the earlier examples was 12% per annum. Figure
4 illustrates the true annual rates for various other compounding frequencies,
but where the nominal rate is the same in every case @ 12% per annum.
This table highlights the fact that unless one knows the compounding
frequency, the nominal rate is meaningless. Moreover the difference is
certainly not trivial.
Figure 4
12% per annum nominal interest with different compounding frequencies.
Compounding
Frequency
Rest Periods
per annum
True annual
Rate
1,000 over
30 years
Annual 1 12.000000 29,960
Half-yearly 2 12.360000 32,988
Quarterly 4 12.550881 34,711
Monthly 12 12.682503 35,950
Daily 365 12.747462 36,577
Hourly 8,760 12.749592 36,597
Continuously Infinite 12.749685 36,598
The true rate rises more slowly at the higher compounding frequencies and
fortunately trends towards a maximum. The practical effect of growing 1,000
over 30 years is shown for perspective.
Over 100 years the difference between daily and annual compounding is
even more staggering:
1,000 @ 12% pa compounding annually produces 83,522,266
1,000 @ 12% pa compounding daily produces 162,434,128
That is a difference of almost 79 million, using the same nominal rate, but
with different compounding frequencies almost double the annual figure!
You can now see the importance of identifying the true rate.
20
Capital repayment loans
As mentioned in the introduction, there are two main methods of loan
repayment:
(i) Capital repayment loans, where capital is repaid gradually
throughout the loan term as part of a regular payment. They are
also called annuity mortgages. The term re-payment is used to
signify a capital element is included.
(ii) Interest-only loans, where only interest is paid during the term,
and the amount owing is settled at the end with a lump sum,
obtained from selling a separate asset, sometimes an
endowment policy or an ISA, or more often the house.
We will first look at capital repayment loans, and take as an example a typical
50,000 level repayment mortgage over 20 years, assuming 8% pa nominal
interest compounding monthly. The complete repayment schedule is
illustrated in Figure 5.
The monthly repayment is made up of two components; interest on the capital
owing at the start of each period, and a capital repayment element, which
reduces the amount owing.
In the early years, when little capital has been repaid, the monthly repayment
mix is mostly interest. As time goes on, more capital has been repaid so the
interest element reduces. There is then more of the monthly repayment
available to repay capital. So capital is repaid faster and faster until it is all
repaid and thats the end of the mortgage it has been amortised, or killed
off.
21
Figure 6
50,000 20 year repayment mortgage @ 8% pa with monthly rests
Debt over Time
0
10,000
20,000
30,000
40,000
50,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year
D
e
b
t
Figure 5
Year Monthly Interest Capital Debt
Payment Element Element Year End
1 418.22 333.33 84.89 48,943
2 418.22 326.29 91.93 47,799
3 418.22 318.66 99.56 46,559
4 418.22 310.39 107.83 45,217
5 418.22 301.44 116.78 43,763
6 418.22 291.75 126.47 42,188
7 418.22 281.26 136.96 40,483
8 418.22 269.89 148.33 38,636
9 418.22 257.58 160.64 36,636
10 418.22 244.24 173.98 34,470
11 418.22 229.80 188.42 32,125
12 418.22 214.16 204.06 29,584
13 418.22 197.23 220.99 26,833
14 418.22 178.88 239.34 23,853
15 418.22 159.02 259.20 20,626
16 418.22 137.51 280.71 17,131
17 418.22 114.21 304.01 13,346
18 418.22 88.97 329.25 9,247
19 418.22 61.65 356.57 4,808
20 418.22 32.05 386.17 0
50,000 level repayment mortgage over 20 years @ 8% per annum compounding monthly.
Note that the interest and capital element shown are for the first month in each year, because
in practice the mix changes month by month.
22
Figure 6 graphically reflects the gentle convex curve of the capital owing over
time. For longer terms it is flatter to start with since the capital element is
smaller and so it pays off the loan more slowly. Figure 7 shows the year-by-
year mix within each monthly repayment between capital and interest.
Figure 7
Capital & interest elements of a mortgage repayment over 20 yrs
0
50
100
150
200
250
300
350
400
450
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year
R
e
p
a
y
m
e
n
t
p
m
Capital Interest
The Flat Rate trap
Before computers were used regularly, lenders had to rely on hand-calculated
figures, and so they often looked for easy short cuts. One such approach is
still seen today and can be very misleading for short term loans unless you
are wary. It is the use of the so-called flat rate of interest.
Let us say a lender provided a loan of 1,000, to be repaid monthly over one
year and simply quoted 14% pa as the interest rate, compounding annually.
You might be forgiven if you thought the following lenders explanation of his
calculation to seem fair.
14% of 1,000 is 140. So in one year, the amount lent including
interest is 1,140. If the loan is repaid in 12 equal monthly instalments,
that works out to a twelfth of 1,140 each month which is 95 per
month exactly, since 12 x 95 = 1,140.
This sounds like a straightforward loan @ 14% pa. But the true annual rate in
this example is actually 27.96 %, which is almost double the quoted rate.
This is because part of the monthly payment is actually repaying capital each
month, so the capital debt is not 1,000 for the whole year. The facile, flat
rate calculation assumed interest was always charged on 1,000 as if it was
outstanding for the whole year, when on average only about half of it was
owed over the period. Thus, the 14% quoted rate is about half the true rate.
The rate of interest of 14% used in this example is a flat rate. The table in
Figure 8 illustrates the schedule that amortises the loan if the true monthly
interest rate is 2.0757 % or 27.96% pa true rate.
In reality, the interest each month is equal to the monthly rate (2.0757% pm)
applied to the debt at the end of the previous month. The debt at the end of
each month is equal to the previous months debt plus interest for the month,
less repayments made in the month. Alternatively, current debt is the
previous months debt less the capital element repaid the calculation works
out the same either way.
23
Figure 8
1,000 loan over 12 months at 14% pa flat rate.
Month
End
Repayment
Made
Monthly
interest rate
Interest
Element
Capital
Element
True Debt
Principal 1,000
1 95.00 2.0757 % 20.76 74.24 925.76
2 95.00 2.0757 % 19.22 75.78 849.97
3 95.00 2.0757 % 17.64 77.36 772.62
4 95.00 2.0757 % 16.04 78.96 693.65
5 95.00 2.0757 % 14.40 80.60 613.05
6 95.00 2.0757 % 12.73 82.27 530.78
7 95.00 2.0757 % 11.02 83.98 446.80
8 95.00 2.0757 % 9.27 85.73 361.07
9 95.00 2.0757 % 7.49 87.51 273.57
10 95.00 2.0757 % 5.68 89.32 184.24
11 95.00 2.0757 % 3.82 91.18 93.07
12 95.00 2.0757 % 1.93 93.07 0.00
The true rate is 2.0757 % per month or 27.96% pa.
Early redemption or settlement - the Rule of 78
Flat rate loans sometimes suffer from another impediment: the so called rule
of 78. Lenders using this rule (and they should state so in their literature)
calculate the redemption figure (ie, the amount paid on early settlement) as
simply the outstanding repayments. So after month one in the example
illustrated in Figure 9, there are eleven payments left: so the actual amount
owing is eleven times the monthly repayment of 95, which is 1,045 yes it
is actually more than you have borrowed! It then reduces by 95 each month
thereafter.
The actual redemption amount owing for a Rule of 78 loan - the same as
that illustrated in Figure 8 - is shown in Figure 9 and compared with the
proper, normal way of calculating redemption, by depreciating the balance as
in Figure 8. Clearly the rule of 78 disadvantages borrowers who redeem early
and its only justification is its so-called simplicity. Lenders who still use it for
short term loans justify its use as covering the expenses of an early
redemption, or early settlement.
The method used is described in the Technical Bits. But suffice to say its
name is derived from totalling up the first 12 numbers of a twelve month loan,
ie 1 + 2+ 3 + 4 + and so on: it comes to 78. This is also called the Sum-
of-the-Digits. The interest elements are then calculated as initially twelve
seventy-eights, then next month as eleven seventy-eights and so on.
24
Figure 9
Rule of 78 redemption compared with normal for 1,000 loan
over 12 months at a flat rate of 14% pa.
Month Monthly Rule 78 Normal Difference
Payment Redemption Redemption
1 95.00 1,045.00 925.76 119.24
2 95.00 950.00 849.97 100.03
3 95.00 855.00 772.62 82.38
4 95.00 760.00 693.65 66.35
5 95.00 665.00 613.05 51.95
6 95.00 570.00 530.78 39.22
7 95.00 475.00 446.80 28.20
8 95.00 380.00 361.07 18.93
9 95.00 285.00 273.57 11.43
10 95.00 190.00 184.24 5.76
11 95.00 95.00 93.07 1.93
12 95.00 0.00 0.00 0.00
This rule is another hangover from the quill pen era. Nevertheless the Office
of Fair Trading has outlawed this method for longer-term mortgages,
particularly non-status loans where one lender in particular abused it. The
OFT will probably ban its use altogether eventually. However, a separate
spreadsheet is included called Rule of 78 for those interested in the
technical calculations. Different lenders may interpret the calculations
differently, often allowing an extra month or two to settle.
Using spreadsheets to calculate true interest
How was the interest rate in Figure 8 calculated? Unfortunately, there is no
known formula for calculating interest rate directly, by substituting all the other
known variables, ie the principal and the repayment schedule. The only way
available to us is by trial and error. This is why comparison exercises
between various loan products have proved so difficult before the advent of
computers.
Fortunately, spreadsheets have come to the rescue. Every serious student of
finance should familiarise themselves with this vital tool, which fortunately is
very easy to learn and use.
The disk attached to this book includes all the key examples in spreadsheet
format. Some spreadsheets are essential to achieve a solution, for example
when comparing any two repayment schedules, in order to identify which one
is the best value for money.
What is a spreadsheet?
For the sake of any spreadsheet novices, it consists of a matrix of cells
rather like a noughts and crosses game but with many more cells, similar to
the tables shown earlier. Letters along the top, and numbers down the side,
are used to refer to each cell. So A1 is the top left hand corner, A2 is the next
cell down and B2 the next cell right and so on.
25
You can then enter figures, text or mathematical formulae in any cell. But the
components of a formula can be referred to by their cell addresses. If you
enter say the number 5 in cell A1, and enter 4 in cell A2, then cell B2 could
contain the formula A1 x A2, which will display 20, ie 5 x 4. If you change cell
A1 from 5 to say 8, all the other cells are automatically recalculated and B2
will instantly display 32, which is the product of A1 and A2, 8 x 4.
Spreadsheets contain dozens of really useful tools and features that enable
you to construct a complex schedule quite quickly. They are fun to build and
invaluable for getting fast and meaningful results.
Goal Seek
So back to how the true interest rate in Figure 8 was calculated. One of the
tools available to a spreadsheet user is Goal Seek (as called in Microsofts
latest spreadsheet named Excel; it is called Backsolver in Lotus 123). This is
a totally automated trial and error process. We need to find an interest rate
that amortises the final capital to zero after 12 months given the fixed monthly
payment. Goal Seek will do this in a flash.
The hard way is to simply enter a succession of trial figures, recalculating
each time and then improving your next trial figure, until you reach the end
capital you want usually zero but not always. The formal way of doing this
is called iteration. This is a structured trial and error process that constantly
recalculates a given formula, making finer adjustments to the required
parameter on each recalculation, until a result of sufficient accuracy is
achieved. Goal Seek does this automatically.
There are some other very useful spreadsheet functions that make use of a
built in iterative process so all the thinking and the action is done for you.
Please see the Technical bits for further details. For the moment, please trust
the figures until you prove them for yourselves using one of the example
spreadsheets provided or by creating a spreadsheet of your own.
The Building Society mortgage trap
One of the facts of life in the mortgage world is that mortgage repayments are
nearly always collected monthly, no matter what the compounding frequency.
Logically one would expect payments to be collected on the same day as the
interest is compounded but tradition, emanating from the non-digital quill pen
era of Building Societies, dictates a more bizarre arrangement. Many Building
Societies, even today, collect monthly but compound annually.
Interestingly, this means that for a repayment mortgage, the true rate of
interest is actually different every year. Like a flat rate loan, the fact that there
is a capital element in your monthly payment is ignored until the year end.
The higher the capital element, the greater the true interest rate.
This is dramatically illustrated in Figure 10, particularly in year 20, where a
true rate of 15.5589% is the surprisingly large result from a nominal rate of
just 8%.
The overall true rate will increase with shorter terms, as illustrated in Figure
11. The overall rate is the true rate taking all the monthly payments for the
actual life of a mortgage rather than just for any one year.
If the number of rests per year (the compounding frequency) were the same
as the number of collections per year, then the true rate would remain
26
constant throughout as shown in the last column. The true rate for an
interest-only loan is the same as for monthly rests 8.3% in this example.
Figure 10
A 50,000, 20 year repayment mortgage @ 8% pa nominal interest, compounding annually,
but collected monthly, and showing the true rate each year.
Year Nom.Int Monthly Debt True rate
% pa payment year end in year
1 8.00 424.38 48,907 8.3858%
2 8.00 424.38 47,727 8.3948%
3 8.00 424.38 46,453 8.4051%
4 8.00 424.38 45,077 8.4167%
5 8.00 424.38 43,590 8.4301%
6 8.00 424.38 41,985 8.4456%
7 8.00 424.38 40,251 8.4636%
8 8.00 424.38 38,378 8.4848%
9 8.00 424.38 36,356 8.5099%
10 8.00 424.38 34,172 8.5402%
11 8.00 424.38 31,813 8.5772%
12 8.00 424.38 29,265 8.6232%
13 8.00 424.38 26,514 8.6820%
14 8.00 424.38 23,543 8.7594%
15 8.00 424.38 20,333 8.8655%
16 8.00 424.38 16,867 9.0192%
17 8.00 424.38 13,124 9.2611%
18 8.00 424.38 9,081 9.6955%
19 8.00 424.38 4,715 10.6995%
20 8.00 424.38 0 15.4489%
Note the true rate increases to almost double the nominal rate in the last year. The reason for
the difference is that capital is being repaid before interest accrues, but no credit is given. The
later years repayments include a higher capital element and hence reflect a higher true rate.
The overall true rate is 8.5125% pa if the mortgage is kept running for 20 years.
The extra interest paid in this example is 1,479 more than for monthly rests
at the same nominal rate. Why Building Societies continue with wacky
arrangement is put down to computer systems but I suspect the extra profits
made in the later years are not unwelcome, and most borrowers are quite
unaware of this anomaly.
27
Figure 11
A 50,000 repayment mortgage @ 8% pa with monthly repayments:
comparing the overall true annual interest rate for different terms and
compounding frequency, or rests per annum.
Term
years
Payment
per month
True rate with
annual rests
True rate with
monthly rests
1 4,500.00 15.4489% 8.3000%
5 1,043.57 9.6334% 8.3000%
10 620.96 8.8806% 8.3000%
15 486.79 8.6329% 8.3000%
20 424.38 8.5125% 8.3000%
25 390.33 8.4433% 8.3000%
Avoiding the trap
Note that this inconsistency only affects capital repayment loans and not
interest-only loans. Moreover, just because lenders compound annually, or
sometimes quarterly, it does not mean they are necessarily poorer value for
money. The overall true rate may still be lower than that for a lender using
monthly rests. The problem is in making the calculation, and the answer is
term dependent. The methods discussed later solve this.
How can you avoid it? Firstly, if you want a repayment loan, particularly a
short term one, favour lenders who compound at or below the collection
frequency. In other words, a lender requiring monthly repayments should
charge interest with monthly compounding or better. Commercial lenders
often collect quarterly. Provided they compound quarterly or more often,
there is not a problem but beware those that dont. By beware, I mean
ensure that the true rate is competitive for the term in question.
If you are already with a lender who compounds annually, try to repay the
loan before the last few years when the true rate is at its highest. A switch to
an interest-only loan would also result in a lower true rate. Alternatively,
switch (re-mortgage) to another lender, with a competitive true rate, but who
compounds monthly or better.
There are some benefits. If you are in arrears with an annual compounding
lender, you may not have to pay interest on outstanding payments within the
lenders charging year. In theory you can default for eleven months and pay
the entire years payment as a lump sum just before the year end, and still not
pay any extra interest. Whether a lender will allow this or not is another
matter, and it would certainly not improve your credit worthiness.
28
Interest-only loans
From the lenders standpoint these loans are straightforward and there are
none of the traps associated with the repayment method. Suffice to say that
the collection frequency is the most relevant parameter. A monthly interest-
only payment implies the interest accrues monthly; the true interest rate is
then calculated the same way as with a repayment loan with monthly rests.
Indeed one can look at an interest-only loan as a capital repayment loan
where the term is infinity, or at least a very large number.
In the 60s and 70s some Building Societies charged a higher nominal
interest rate for endowment mortgages than for repayment mortgages, to
compensate for the lower return achieved when capital was not repaid
monthly. That is rare today but the anomaly still exists, when rests are
annual, where for the same nominal rate, interest-only borrowers enjoy a
lower true interest rate than that for repayment borrowers.
The key to the value-for-money measurement of an interest-only loan is the
performance of the separate repayment vehicle and this is discussed in
Part II, along with the reasoning behind choosing this method.
Glossary and summary so far
Before summarising some of the basic principals of compound interest
discussed so far, let me first list some definitions: -
Principal Initial lump sum of cash or capital borrowed or lent. It can
also be referred to as the present value in a financial
formula.
Interest An additional amount of money arising over a set period of
time measured as a percentage of the capital amount owing
at the start of the period.
Rests The number of times a year interest is accrued. Also called
compounding frequency or accrual rate.
Periods The number of time intervals in which interest accrues over
the term of a loan. A 5 year loan with monthly rests would
have 60 periods in total.
Nominal Rate The interest rate often quoted by a lender. It is usually the
periodic true rate multiplied by the number of periods in a
year. Thus 12% per annum nominal is a true rate of 1% per
month, equivalent to a true rate of 12.6825% per annum.
True Rate An accurate interest rate that takes account of compounding
frequency. It can be quoted per period, e.g. 2% per quarter,
or converted to a true annual rate.
Flat Rate A simple interest rate added on to the principal for each year
of a loan. The periodic payment is calculated by dividing the
total capital plus interest by the payment frequency. It is a
misleading rate used originally to simplify loan calculations
but is seldom used by reputable lenders.
Rule of 78 A bizarre rule to ensure that outstanding debt always equals
outstanding payments - a practice that ensures a higher
29
redemption amount than with a conventional, decreasing
balance calculation. Lenders operating under the rule of 78
must inform borrowers of the fact as it is like suffering an
extra early redemption penalty.
Payment The number of payments made/collected during a year.
Frequency This is not necessarily the same as compounding frequency.
Building Societies often compound annually, but collect
monthly, leading to some anomalies. Some calculate daily
and compound monthly which makes more sense.
Repayment The amount required to amortise a loan over a given term.
Amortise means reduce the loan to zero - to literally "kill" the
loan. A repayment usually contains both a capital and an
interest element. Interest is calculated first, at the given rate
times the capital owing. The difference between the total
repayment figure and the interest element is the capital
element, which is then used to reduce the total capital owing.
Repayments can be made either at the start of a period (in
advance) or the end (in arrears) of the period. Loans are
usually repaid in arrears whereas some investments, such
as annuities, can be paid in advance.
Future Value This is any future amount owing consequent on capitalised
interest less any repayments. The fundamental formula for
future value at the end of every period is always the previous
amount owing, plus interest, less repayments made in the
period. This is a general-purpose relationship and applies
even when the interest or the repayments vary every period.
Redemption Terminating a loan earlier than the full term. Also referred to
as early settlement.
Comprehension check
Now lets summarise what we have discussed and highlight the main
discoveries so far.
Simple interest is a waste of time for proper comparisons since it does
not take account of capitalised interest: compound interest does.
Compound interest requires us to know the compounding frequency, in
other words, how often interest is capitalised.
Compound interest is charged on capital owing at the previous period.
The true rate of interest, usually calculated annually, is an accurate
way of comparing different schemes for value for money. There is no
formula for it and it needs special trial and error procedures to
calculate it.
Compounding annually but collecting monthly (like some Building
Societies) is an anomalous method for repayment loan calculations,
which ignores capital paid before the year end, and results in the true
interest rate being larger the higher the capital element.
30
Flat rates of interest can significantly understate the true rate. Lenders
using the Rule of 78 inflate the early redemption, or settlement amount.
The nominal rate per annum is most often quoted, but you need to
know the compounding frequency to determine the true rate.
Just because lenders compound at different frequencies does not
necessarily mean they are better or worse value-for-money. The true
rate, calculated over the anticipated life of the loan, is the only ultimate
criteria.
Interest-only loans do not suffer from compounding anomalies but the
true rate of interest depends on the payment frequency.
Daily Interest
One final footnote: some lenders say they calculate interest daily. This
does not necessarily mean they compound daily. Most likely this means
monthly compounding (i.e. monthly rests) but a simple interest calculation for
any transactions made during the month. These transactions quite properly
take account of the day in the month it took place, but there is no formal daily
compounding. This is a sensible and fair method of calculation and should be
adopted by every lender seeking transparency.
- oOo -
31
The Internal rate of Return - IRR
In the real world, interest rates are seldom fixed for long. There are also fees,
charges and penalties to consider. As if compound interest wasnt
complicated enough, we now have to consider a whole new set of variables.
Fortunately all is not lost as there is a very important and quite straightforward
mathematical function called the Internal Rate of Return, or the IRR, which is
basically like the true rate of interest but it can cope with varying interest rates
and varying payments during the repayment schedule as well as the
occasional fee.
Take the 1,000 loan illustrated in Figure 12, which displays different interest
rates each month. The repayments are re-calculated each month to amortise
the loan from that point assuming the new rate is unchanged.
Figure 12
A 1,000 loan over 12 months at varying interest rates.
Month
End
Interest rate pm
(varying)
Repayment
Schedule
Debt
Start -1,000.00 1,000.00
1 1.0000% 88.85 921.15
2 1.5000% 91.46 843.50
3 1.4000% 90.98 764.33
4 2.0000% 93.64 685.98
5 1.0000% 89.65 603.19
6 0.5000% 87.90 518.30
7 0.7500% 88.67 433.52
8 1.0000% 89.32 348.53
9 1.2500% 89.87 263.02
10 1.3500% 90.05 176.52
11 1.7500% 90.58 89.02
12 1.5000% 90.36 0.00
The Internal Rate of Return is 1.2257% per month or 15.7414% pa true
Now, lets guess what the interest rate would have to be if it was fixed, but
where the monthly repayment schedule still stayed the same as in Figure 12,
amortising the debt to zero after twelve months. It comes out to 1.2257% per
month or 15.7414% true rate per annum. Figure 13 over the page, illustrates
why.
The table shows the identical monthly repayment schedule as shown in
Figure 12. But, the interest rate column is now a fixed rate. The only column
that has changed is the theoretical monthly debt, which differs because the
monthly interest rate is different, although it still amortises to zero. The
borrower makes the same payments and still repays the loan, but the interest
rate is fixed instead of variable.
32
This fixed interest rate is called the Internal Rate of Return, and is expressed
as a true interest rate, usually annually. It is a very powerful tool when used
to compare two different schedules, one of which might be more favourable
than the other.
Figure 13
This is the same repayment schedule as in Figure 12 but with a fixed interest rate equal to the
Internal Rate of Return the IRR.
Month
End
Interest rate
fixed = IRR pm
Repayment
Schedule
(no change)
Theoretical
Debt
-1,000.00 1,000.00
1 1.2257% 88.85 923.41
2 1.2257% 91.46 843.26
3 1.2257% 90.98 762.62
4 1.2257% 93.64 678.32
5 1.2257% 89.65 596.98
6 1.2257% 87.90 516.40
7 1.2257% 88.67 434.07
8 1.2257% 89.32 350.06
9 1.2257% 89.87 264.48
10 1.2257% 90.05 177.67
11 1.2257% 90.58 89.27
12 1.2257% 90.36 0.00
The IRR is a fixed interest rate that would amortise the actual repayment schedule to the
same final result zero in this case. Only the payment schedule is needed.
The IRR is a single number that represents the whole payment schedule,
regardless of variations caused by numerous actual interest rate changes.
The IRR looks only at the payment schedule, and ignores the variable interest
rates that produced it. So this one rate can represent many.
You will need to use a spreadsheet to calculate the IRR or use a specially
written program. There are two main ways of calculating it. If you have laid
out the schedule as in the third column of Figure 13, you can use the
spreadsheet function IRR (range, guess) to produce the answer. A more
general approach is to use the Goal seek function which will calculate the rate
required to amortise any given schedule, even if the schedule is defined by
formulae rather than having to lay out the whole schedule difficult for a 25
year mortgage with 300 different monthly payments. The techniques are
easier to see with the sample spreadsheets in front of you.
It is important to use a sign convention when working with IRRs. Cash
coming out could be negative with cash going in as positive there must be
at least one positive and negative figure in the range. Note the initial loan is
shown as a negative figure whereas the repayments are positive.
33
Adding Fees and Charges
In summary, the IRR is the theoretical fixed interest rate required to amortise
any given loan repayment schedule, regardless of how that schedule was
derived. It is now really quite easy to add in any additional numbers in the
schedule, such as fees and charges, at the appropriate point in time.
Take the example in Figure 12 and 13. Suppose the lender charged a 50
up-front fee. The starting cash payment was originally minus (-) 1,000 to
reflect the initial 1,000 loan being received by you (remember the sign
convention). We now simply change this to -950 to take account of the 50
fee. We do not change the scheduled repayments in any way. In other
words, of the 1,000 you applied for, you had to give the lender 50 so you
only benefited from 950. But the actual repayment schedule is still
calculated as if you borrowed 1,000.
The new IRR in this case is 27.6239% pa, up from 15.7414% pa, all because
of a 50 (5% of the loan) up-front fee. If the fee were charged at the end of
the loan instead of the beginning, the new IRR would be 25.08%, lower than
when charged up front, illustrating the importance of timing. It can make quite
a difference over a longer term.
The total amount paid out over the term, including all costs, will be the same
whenever the fee is charged. But the IRR uncovers the truth and indicates
that a later charge implies a cheaper loan. Although regulations insist on this
total payable figure being quoted, it is not helpful when comparing one loan
with another; only the IRR (and its cousin the APR) accurately reflects the
important effect of cash flow timing.
The IRR is a potent tool
So to summarise, the IRR is the most potent tool we have available to
analyse and compare different sets of loan schedules. It takes into account
varying interest rates and repayments as well as fees and charges along the
way and importantly, when they are made. The IRR comes from the same
family as true interest rate. But the IRR is a much more sophisticated and
thorough measure, as it can account for any cash flow schedule, and is
therefore particularly good for loan comparisons.
APR
The 1974 Consumer Credit Act (known as the CCA and now amended)
aimed to bring truth in lending to the attention of the public and to
businesses providing credit. This Act first introduced the concept of the APR
to the UK, which stands for Annual Percentage Rate. It was meant to be the
laymans version of the IRR. It was designed to be a comparison tool and
was calculated on much the same principles as the IRR. The CCA laid down
how and when the APR was to be used when advertising loan products, and
indeed any credit agreement.
But, until April 2000, the APR suffered from a number of important
weaknesses as far as the mortgage business was concerned, the foremost
being its incomprehensibility the rules were complex and the average
person didnt really understand it. But at least it forced lenders to quote a
figure that took account of fees, costs and their timing as well as sorting out
the true interest rate from the various anomalies we discussed earlier. But it
also produced some dangerously erroneous results.
34
The CCA previously required lenders to calculate the APR in the same way
as the IRR but the method imposed required two critical assumptions: -
1. The interest rate used in the calculation of the payment schedule
must be assumed to be fixed throughout the entire term of the loan
(even if it isnt) and must be the same as the initial rate. So if a
lender offered a loan at 2% pa nominal for the first year followed by
8% pa for the remaining 24 years, the APR was calculated as if the
interest rate was only 2% pa fixed for the entire 25 year term!
Clearly this makes a total nonsense of todays mortgage products
where early rate discounts are common.
2. The term over which the calculation is made is the full contractual
term. In practice, most mortgages last around 6 years before
people move house or re-mortgage. Moreover, there can be
redemption penalties for stopping a loan early. Without taking into
account the expected life of the loan, the APR can produce a
misleading result.
The accuracy rules for the APR were also bizarre. When quoting it one had
to truncate to one decimal point, not round. So an APR of say 7.69% had to
be quoted as 7.6% and not rounded to the more sensible 7.7%. It could also
be quoted up to 1% too high but no worse than 0.1% too low.
In fairness to the original drafters of the legislation, the CCA was conceived in
a period when PCs and spreadsheets had yet to be invented, and so they
attempted to make it easy to calculate by producing sets of tables.
Regretfully, both the public and the lenders themselves soon lost faith in the
accuracy of the APR because of examples above. So, what started out as an
excellent and fair concept, originally billed as truth in lending, turned out to
be untruthful in many cases, and the whole Act ended up giving quite the
opposite effect to what was intended, ending up mistrusted as a result.
In reality, interest rates do vary and loans are repaid early.
The New APR
In early 2000, a new definition of the APR was introduced. The main
breakthrough is that the new APR must now take account of any interest rate
changes during the term. This move rectified the most important anomaly
and as a consequence of this one step, we can now have significantly more
confidence in the APR as a comparator for todays loan products.
The truncating nonsense has also been removed and normal rounding is in.
One decimal point is considered sufficient but lenders are still strangely
allowed the same 0.1% tolerance (lee-way) as before for under quoting. So
an accurate rate of 7.44% can still be legally quoted as low as 7.3%. On a 25
year interest-only mortgage of 50,000, this can be a lee-way of 1,750
overall. Lenders can also over-quote by a full 1%. A 7.44% accurate APR
could also be quoted legally as 8.4% although why anyone would want to do
this is unclear. Unfortunately, this relaxed attitude over accuracy is sufficient
to camouflage some of the subtleties of many loan products. It is a pity to
define an intrinsically very accurate methodology, now easy to calculate, and
then hobble the answer that it produces, thus rendering it as significantly less
useful as an accurate comparison tool.
35
The Act is now clearer on what additional charges need to be included by
defining the TCC the Total Charge for Credit which states exactly what
charges are to be included with the payments, and what charges need not be
included, before calculating the APR. For example, if payment protection
insurance (PPI) is compulsory, it should be included in the TCC, but not if PPI
is optional.
Comparing TCCs is not recommended, as it is merely a total to prove the
charge inclusions and the total gives no clue on the timing of any payment.
Less happily, the full loan term must still be used to calculate APR regardless
of the actual life expectancy of the loan. In practice there is little the
legislators could do about this since they cannot predict ones personal
choice, so at least it is consistent. But it can produce erroneous results.
As an example, take a hypothetical 25 year interest-only mortgage where the
interest rate for Scheme A is 7% pa (with monthly rests) throughout the term,
and there are no additional costs or fees, to keep it simple. I have used the
Loan Comparator spreadsheet to produce the following.
Scheme A
The APR over 25 years is 7.2%
The IRR over 6 years is 7.2%
If the initial interest rate was 5% pa for 24 months, increasing to 7.5%
thereafter (Scheme B) the following picture emerges: -
Scheme B
The APR over 25 years is 7.3% (higher APR)
The IRR over 6 years is 6.8% (lower IRR)
If one relied on the APR alone, it would tell us that scheme A is cheaper. But
if the borrower was to move in 6 years time, the 6 year IRR indicates
significantly better terms with scheme B: so Scheme B is cheaper for most
people. The APR, while insisting on using the full contractual term, is
producing misleading signals to the prospective borrower.
In short, one must still look to the IRR for an accurate appraisal, which takes
account of all the relevant factors including the likely product life. Although
the new APR is a lot better than the old, it is still not accurate enough for a
proper comparison. The IRR remains the paramount tool.
The Net Present Value NPV
This function is similar to IRR but calculates the equivalent present value of a
range of future cash flows, given an interest rate. In other words, what would
all those cashflows be worth today assuming a required IRR if you had a
single lump sum instead, replacing the future streams of incomes and
outgoings.
If the cashflow schedule is the same one as that used for calculating the IRR,
and the IRR is used as the interest rate in NPV, the NPV will be exactly zero.
One can compare and evaluate different cash flows by comparing their Net
Present Values. In some ways, the NPV as a cash lump sum is easier to
visualise, and is particularly useful when evaluating the costs of switching
mortgages as you must do before making a re-mortgage decision. It can be
36
likened to a cashback calculation. But you must be careful to use the correct,
relevant interest rate assumption.
Some examples of the NPV in action are shown in the Loan Comparator
spreadsheet and in Part II. But as another example, lets us look at the same
two schemes described above, comparing IRRs and APRs.
The results in the table below show that scheme B is better value over six
years because the IRR is lower as before, despite the APR being higher.
Scheme IRR (6 yrs) APR (25 yrs) NPV over 6 yrs
(Cashback)
A: 7% pa throughout
the term
7.2 % pa 7.2 % pa 1,100
B: 5% pa for 2 yrs,
7.5% thereafter
6.8 % pa 7.3 % pa -1,105
But the NPV of scheme A over six years compared to scheme B is 1,100.
This means that if there was a cashback of 1,100 with scheme A, the IRR
would then be identical to scheme B. Alternatively, if there was an additional
lump sum fee of 1,105 on scheme B, (ie a negative cashback) it would
equate to the IRR for scheme A.
So you can visualise scheme A being around 1,100 more expensive an
easier figure to imagine than the IRR difference. Another way of looking at
the comparison is that you would need a monthly payment reduction of
18.51 for the six years with scheme A to make it comparable: this monthly
alternative is also shown on the spreadsheet.
Accuracy warning
And now some words of caution. Any future interest rate data that you enter
in these calculators, such as the Loan Comparator, is usually just a guess
as to what those rates will be in practice. In real life, interest rates are hard to
predict; in fact impossible over a long period unless fixed at outset. So any
comparison tool is only as good as the guesses made for the relevant
variables.
Fortunately, in most cases, while the actual numbers, such as the IRR, may
turn out to have been inaccurate in practice, the comparisons might well
remain valid. In other words, if future rates turn out to be higher or lower than
predicted, the difference should be fairly consistent on each comparison if the
margins remain consistent, so the value-for-money ranking should therefore
not change.
Where this may not be true is with loans with an initial fixed rate, changing to
a variable rate later, when comparisons include both these rates within the life
range of a calculation. A different variable rate guess can then easily change
the value-for-money order.
Margin lock or linked rates
Some newly launched lenders offer attractively low variable rates and
incentives just to get noticed, but may increase their margins later on, once
they have grown large enough and become established. After a loan has
37
been started, most borrowers become complacent, and seldom re-check the
validity of their first decision later on and rarely notice wider margins.
This somewhat cynical observation tends to apply to most new product
launches in order to attract public and media interest. An exception would be
where the interest rate is specifically linked (usually by a fixed margin) to an
independent base rate, such as Bank of England Base Rate, or LIBOR, the
London InterBank Offered Rate. With such linked rates, the lenders margin is
effectively locked in throughout the loan, so whatever happens to rates in
future, the interest rate formula will always remain the same.
For example, a lender might advertise a rate that is always a fixed 1.5%
above 3 month LIBOR. You can look up this rate in the newspapers, as it is
independently set. The only downside is that your payment will then alter
every time the linked rate changes, which could also be every three months.
On the other hand, the lender is then committed to that margin. This might
seem attractive but improving new digital technology is constantly enabling
lenders to reduce their administration costs. It could well turn out that some
lender might offer an even lower margin in future.
In summary, although the calculation results are themselves very accurate,
real life may turn out to be different. Market forces may eventually lower the
projected variable rates, which, at worse, could invalidate your initial analysis
of the best-buy. You can minimise this happening by trying a range of
guesses before finally making up your mind. Life wasnt meant to be too
easy.
- oOo -
38
39
Louis Law: One and one does not necessarily make 11.
The Technical Bits
This section is for those who wish to delve deeper into the maths and to
understand the formulae connected with many financial questions.
Firstly, it will be helpful to list some of the key financial formulae that can be
used in computer programming or when using spreadsheets, many of which
can also be worked on a normal hand calculator.
The principle questions about either a loan or an investment can be answered
using a maximum of just five key mathematical variables: -
n The total number of time periods. A two year loan with monthly
compounding would have 24 periods of one month each. The
standard formulae assume n is also the number of payments
i The true interest rate per period (expressed as a fraction - ie the %
rate divided by 100) and assumed to be constant for n periods.
pmt The payment per period, normally constant although it can vary by
prescribed rates, such as annual increases.
pv Present value or the Principal or the capital as at today.
fv Future value of capital after n periods.
Loan repayments
When the payment made to a lender includes both capital and interest, it is
referred to as a re-payment. To calculate the repayment figure (pmt) per
period, given interest rate, initial & final capital & the total number of periods:-
pmt = pv x i / (1 - (1 + i)
-n
) - fv x i/((1 + i)
n
-1) ---------------- (1)
where i is the fractional interest rate per period, n is the total number of
periods and fv is any future value: these variables are the same ones listed in
the previous paragraph. If the loan amortises to zero, which is normal for a
repayment mortgage, fv is zero so the second term can be ignored and then:
pmt = pv x i / (1 - (1 + i)
-n
) ------------------------------------------
(2)
Note that (1 + i)
n
is the same as 1 / (1 + i)
n
Instead of using the sign for division (which might be confused with a minus
sign) it is clearer to use / as a division sign.
So a loan of 10,000 over five years @ 9 % per annum nominal interest
compounding monthly (ie 0.75 % per month true rate over 60 months)
requires a monthly payment of : -
10,000 x 0.0075 / (1 - (1 + 0.0075)
-60
) = 207.58 per month.
The payment calculated with this formula is always the payment made per
period (in arrears) but which may not necessarily be the same as the desired
payment frequency.
So, to calculate a loan where repayments are made monthly, but interest is
compounding annually (i.e a typical Building Society mortgage), formula (2)
above will calculate the annual payment. This is because these formulae all
40
require the payment frequency to be the same as the compounding
frequency. Having calculated the annual payment, you simply divide it by 12
to get the monthly payment.
Suppose a Building Society lends 50,000 over 25 years and charges a
borrower 6% pa compounding annually. What is the monthly repayment?
The annual payment is: -
50,000 x (0.06 / (1 - (1 + 0.06)
-25
) = 3,911.34 per annum.
Dividing by 12 gives us 325.94 per month.
These answers can be checked out using the Loan Comparator
spreadsheet supplied.
Another general-purpose monthly repayment formula that takes a nominal
rate and produces a monthly repayment is: -
pmt.pm = pv x Nom / 12 / (1 - (1 + Nom/p)
(y
x
p)
) ------------ (3)
where p is the number of periods or rests per annum, Nom is the nominal rate
as a fraction (ie the true rate per period x p), y is the total term in years so
y x p is the total number of periods. Whilst formula (2) is more fundamental,
formula (3) is actually more useful for mortgages as it automatically deals with
different compounding frequencies and always produces a monthly answer.
Calculating true rate per annum from the nominal rate
In general, the kernel within most formulae for compound growth calculations
is (1 + i)
n
where i is the fractional interest rate per period and n is the total
number of time periods and repayments.
1 will grow in 12 months @ 1% per month by the factor (1 + 1/100)
12
which
works out to 1.12682. This is because we first add on 1%, ie 1.01 times the
initial capital. Next month we add on another 1% of the new, higher amount
now making it 1.01 x 1.01 of 1. In twelve months that will be 1.01 x 1.01 x
1.01 and so on 12 times. This is the same as saying 1.01 to the power of 12,
written as 1.01
12
. If we were dealing with simple interest the growth factor
would be 1.01 times 12 instead of 1.01 to the power of 12.
To convert a monthly true rate of interest to an annual true rate, use the
formula below where m is the monthly rate expressed as a fraction: -
True Rate pa = (1 + m)
12
- 1
The answer is expressed as a fraction so multiply by 100 to get the
percentage.
Using this formula, 1% per month is equivalent to a true rate of 12.6825 % per
annum. If you do not have a calculator that performs powers, you can use an
ordinary calculator and repeat the multiplication 12 times.
The more general formula used to calculate the true rate from any nominal
rate is
True Rate = (1 + Nom / p)
p
1 ---------------------------------- (4)
where Nom is the nominal rate per annum (expressed as a fraction) and p is
the number of periods per annum. This is the same formula used earlier but
with Nominal rate per annum being used instead of the true rate per period.
41
Suppose a lender charged 8% per annum compounding quarterly so p = 4.
The true rate is (1 + 0.08 / 4)
4
1 = .082432 = 8.2432 % pa true.
This formula applies to any loan or investment where any payments, if they
are made at all, are at the same frequency as the interest compounding
frequency. The true rate formula therefore applies to interest-only loans, like
endowment mortgages, as well.
But the true rate calculation is different if repayments are made say monthly
but interest is compounded annually. It is then necessary to look at the actual
cash flows and use a trial and error method, an iteration process or a special
spreadsheet function, as used in the example in Figure 8.
Natural growth
Note that in the example shown in Figure 4, the true rate for 12% pa nominal
is tending to maximise at 12.749685. The higher the frequency you
compound at, the nearer true rate will approach a maximum, but never quite
reach it. There is an analogy here to natural growth. Living cells might grow
continuously rather than in monthly spurts, and compounding continuously is
perhaps the most natural way for all compound interest calculations. But it is
not so easy to write it all down so as to follow the calculations period by
period, as required in a simple monthly statement.
For pure maths students it is interesting to note that when i is 100% and the
period approaches infinity, the formula (1 + 1/p)
p
is approaching 2.718281.
This is one of the few magic, irrational numbers in mathematics like (pie),
which is the circumference of a circle divided by the radius. This one is called
e (After Euler- a great classical mathematician) and is essential in many
areas of pure mathematics and is the base for natural logarithms.
The growth analogy is relevant for cells which double continuously (ie a
nominal growth rate of 100%). e is like and is an indeterminate number
where the decimal figures go on for ever to whatever accuracy you desire.
Interestingly e is linked to by another strange number called i, which is the
square root of 1 and is an imaginary number. (This i should not be confused
with the i for interest used in financial calculations).
The remarkable formula that connects all three with the two other special
numbers, 0 and 1 is: -
e
i
+ 1 = 0
but that is another, fascinating story.
- oOo -
42
Murphys other law: If mathematically you end up with the incorrect answer, try multiplying by
the page number.
Other Formulae still in the Technical Bits
(Please move directly to Part II if it gets too heavy!)
Cash flow sign conventions
It is helpful to set a convention when dealing with positive and negative
answers to financial formulae. One convention is to assume that all
payments in are negative and all payments out as positive. You can put it
the other way round but you just have to remember what a negative or
positive result actually means.
Future Value
In a repayment mortgage, it is often useful to know what the capital owing will
be after a set time period. You have already met the somewhat trivial formula
for calculating Future Value (fv) from Present Value (pv) assuming no
repayments. This simple calculation is: -
fv = pv x (1 + i)
n
But there are usually regular payments involved and then the following
general formula is more useful: -
fv = pv x (1 + i)
n
- pmt x (((1 + i)
n
) - 1) / i --------------------- (5)
As before, this formula requires the pmt frequency to be the same as the
compounding frequency so i is the fractional rate per period, n is the number
of periods and pmt is the repayment per period: pmt is negative if investing.
As an example, let us take a mortgage of 50,000 over 25 years at the rate of
6% pa compounding monthly. The monthly rate, i is then 0.06/12 = 0.005 %
pm. The period, n is 25 x 12 = 300 months.
We must first work out the repayment, if not already known, using the earlier
formula (2): -
pmt = pv x i / (1 - (1 + i)
-n
)
This gives 50,000 x (0.005 / (1 - (1 + 0.005)
300
) = 322.15 per month.
Now suppose we wish to calculate the capital owing in five years time or 60
months. Using formula (5) gives: -
50,000 x (1+.005)
60
- 322.15 x (((1 + .005)
60
) - 1) / 0.005 = 44,966
That is obviously a long-winded calculation. Clearly the use of spreadsheets
is a great advantage here, as you need only enter a general-purpose formula
once. You then simply enter the variables to produce an instant answer.
If pv is zero, formula (5) simplifies to: -
fv = - pmt x (((1 + i)
n
) - 1) / i
Why is the result negative? The answer is because if there is a zero
principal, any further payments will start to overpay the debt the debt is
negative. One would normally use this formula as an investment rather than
a loan. In this case one would start with nothing (pv = 0) so: -
fv = pmt x (((1 + i)
n
) - 1) / i
43
If one invests say 100 per month at 1% per month for 12 months the
resultant capital is given by: -
100 x (((1 + .01)
12
) - 1) / .01 = 1,268.25
Repayment vs Endowment
One of the false arguments often put forward to support endowment
mortgages (interest-only plus an endowment policy) is to consider what
happens when you move house in a few years time. The argument goes as
follows. An endowment mortgage theoretically always finishes on the same
date, which is whenever the endowment policy matures, regardless how often
you move because you use the same endowment policy for each new
mortgage. So if you borrow the same amount, the monthly cost remains the
same despite the new term of each new mortgage being shorter.
This argument is quite correct so far. But then it goes
With a repayment mortgage, so little of the loan has been repaid in
the early years that you have to borrow virtually the same amount
again when you move. So to keep the cost down to the same level as
before, the mortgage term has to be the same as it was, so projecting
the mortgage end date further into the future: any shorter term would
increase the monthly repayment. But the wonderful endowment
mortgage does not need extending to keep the cost the same!
This argument is quite wrong, and we can see why when we apply some
basic mathematics to the repayment mortgage.
Suppose you have a 50,000 bank mortgage over 25 years @ 6% pa
compounding monthly, as in the last example. We worked out that it requires
a payment of 322.15 per month.
If you then move house after say 5 years, we have already calculated the
amount you have to pay to redeem the mortgage in five years time as being
44,966. So, supposing you wanted to borrow 44,966 again but over 20
years this time to end on the same date as before as you would with an
endowment mortgage. What is the monthly repayment?
Applying formula (2) we get: -
44,966 x (0.005 / (1 - (1 + 0.005)
240
) = 322.15 per month
This is precisely the same figure you were paying before. When you think
about it is has to be so: when you redeem, you pay back with a lump sum but
an instant later, you borrow precisely the same amount again, so the
schedule should not change in any way. There is no payment difference over
the new shorter term and so no term increase is required to maintain
unchanged monthly costs. What is different is that you need to borrow less
each time you move with the repayment mortgage. But now you can prove it!
Term
Given the payments and the interest rate it is possible to work back to the
term (n) of the loan (pv). The following formula uses logarithms to any base:
n = - log(1 - pv x i / pmt) / log(1 + i) ---------------------------- (6)
So reversing the earlier bank mortgage calculation where pv is 50,000, i is
.005 and the pmt is 322.15, this formula produces n = 300 months (25
years) as expected.
44
Present Value
Occasionally one needs to calculate the Principal (Present Value, or pv) given
certain other variables. Fortunately by rearranging the formula (5), pv can be
readily derived. Take formula (5): -
fv = pv x (1 + i)
n
- pmt x (((1 + i)
n
) - 1) / i)
By rearranging
pv x (1 + i)
n
= fv + pmt x (((1 + i)
n
) - 1) / i)
So pv = (fv + pmt x (((1 + i)
n
) - 1) / i) / (1 + n)
n
You can tinker with this formula to improve the look but the result is the same
however it looks. If fv is zero, pv is equal to the Principal for a repayment
mortgage. The formula is then better arranged to: -
pv = (pmt x (1 - (1 + i)
-n
)) / i
An application might be to calculate what size loan one can afford given the
monthly payment and the interest rate. Say you could manage 500 per
month over 25 years and the rate of interest is 6% pa throughout,
compounding monthly as before. The Future Value (fv) is zero as the loan
amortises to zero. So the Principal is given by: -
(500 x (1 (1 + 0.005)
-300
)) / 0.005 = 77,603
This means that 500 per month could support a 77,603 mortgage given the
6% interest rate. In practice, interest rates are seldom fixed for long and it is
necessary to make a guess as to the future average interest rate. This task is
almost impossible but there is a way round it using flexible payment
mortgages, as discussed in Part II.
Increasing payments
This is a more complex formula, and is used for any annuity calculations
where the monthly payment increases annually by a fixed amount: it was also
used for the original Flexible Payment Mortgage in the eighties.
Assume the initial loan/investment was pv and the final debt was fv, ( ie zero
if it was a repayment mortgage or an annuity. Nom is the nominal interest
rate per annum, t is the true interest rate per annum and j is the percentage
payment increase rate every 12 months. Rates are not expressed as
fractions in this formula.
Pmt = (A * pv B * fv) * (Nom * (t j) / (1200 x t))
Where A and B are factors calculated as follows: -
A = 1 / (1 (1 + (t j) / (100 + j))
y
) where y is the term in years
B = 1 / ((1 + t / 100)
y
(1 + j / 100)
y
)
An example would be an annuity type mortgage of say 100,000 amortising
to zero over 25 years at 7% pa nominal, compounding monthly, and with
payments escalating at 5% per annum. The true rate, t , comes out to
7.2290% pa, j is 5, A is 2.44774 and B is 0.42752. Note that B is not actually
required if fv is zero.
The initial payment is then 440.27 per month, escalating by 5% pa.
45
This calculation produces the same result as an investment of 100,000 into
a 25 year temporary annuity, with monthly payments of 440.27 per month,
escalating by 5% per annum.
Flat rate loans and the Rule of 78
For a flat rate loan L at f % pa over M months, the total interest payable, T is
given by: -
T = Loan x f% x M / 12 and the monthly payments, P = (T + L) / M
The interest element in month n of a loan of M months max is given by
I = T x 2 x (M + 1 - n) / M x (M + 1)
The remaining interest R still due is T minus all the Is for each month to date
or from the following: -
R = T x (M + 1 n) x (M n) / M x (M + 1)
The redemption (early settlement) capital owing is P x (M n).
So for a 1,000 loan over 12 months at 14% flat, T = 140
P = 1,140 / 12 = 95 per month.
In month 6 (n = 6) the interest element is 140 x 2 x 7/ (12 x 13) = 12.56.
The capital element is 95 12.56 = 82.44
The redemption figure is 95 x 6 = 570 which includes outstanding interest.
The true monthly interest in this example is 2.0757%, calculated by any of the
methods described herein.
Spreadsheet solutions
All the above formulae are made much easier by using spreadsheet functions
and for the sake of completion, the main Excel functions are summarised
below but using the same classical variable definitions we used before.
Excel is the spreadsheet application created by Microsoft and is used by
around 80% of all spreadsheet users. It is often bundled in free with new
computer applications or included in the Works suites. Lotus sells their 123
spreadsheet, which does read Excel spreadsheets except some of the more
exotic functions (which sadly often include the financial functions). The layout
can also need adjusting in some cases.
Functions use a series of parameters in brackets, some of which can be
omitted. As with the formulae, the assumptions are that the interest rate is
fixed, that the periods are of equal time and the payments are also constant
and coincide with the rest period.
Payment (pmt) is given by PMT (i, n, pv, fv, type)
where type is either 1 for payments in advance or 0 (or omitted) for the more
normal payments in arrears. Alternatively you can remember the simple rule
that you can convert from advance payments to arrears by simply multiplying
or dividing the result by (1 + i).
The fv variable is also optional but is useful where the loan does not amortise
to zero but to a positive balloon payment. It is also useful for a mixed
mortgage, which is part repayment and part endowment where the future
value is the endowment element.
46
It is important to remember the sign convention for positive or negative
cashflows. Substituting positive figures in PMT will always produce a
negative result to indicate that you make the payment (outwards movement)
as opposed to the pv which is the sum you receive (inwards movement) and
so it is positive.
Excel defines n as nper, which means both the number of payments and the
number of periods. This forces the user to accept that these formulae
assume the payment frequency to be the same as the compounding
frequency. We can still think of n as the number of periods provided we
remember that the result is a payment per period, which is not necessarily per
month.
If we are calculating a Building Society repayment where the interest is
compounded annually, i must be the annual rate, n is then in years and PMT
calculates the annual payment. The monthly payment is then obtained by
dividing the annual payment by 12. We have seen earlier that this produces a
true interest rate anomaly where the true rate differs every year.
Future Value is given by: FV(i, n, pmt, pv, type)
Present Value is given by: PV(i, n, pmt, fv, type)
Term (n) is given by: NPER(i, pmt, pv, fv, type)
Deriving the interest rate
As stated earlier there is no way to rearrange any of the earlier formulae to
obtain interest rate. You are of course welcome to try! But there are several
approaches of which the easiest is to use a spreadsheet with a RATE
function or similar.
i is given in Excel by RATE(n, pmt, pv, fv, type)
This looks so simple, but there is a lot of iterative computation going on
underneath the bonnet. Fortunately we do not need to open the bonnet to
use the function. Remember that this function assumes fixed interest, fixed
payments made at the same time as interest compounds, and constant time
intervals.
The old Hewlett Packard financial calculators produced excellent results and I
still, to this day, use a 15 year old HP12C. It has the five main financial keys
i, n, pmt, pv and fv. You enter any four known ones (with zero if relevant) and
press the fifth key for the calculation of the unknown variable. Calculating the
interest takes some seconds, as the calculator goes through its iterations
(automatic trial and error) to eventually hone in to as accurate an answer as
possible.
The Internal Rate of Return IRR
All the formulae & functions up to now assume that the interest rate is fixed,
that the periods are of equal time and the payments are also constant and
coincide with the rest period.
But the IRR is the theoretical fixed interest rate that can apply to any cash
flow schedule however caused (by varying interest rates, payments or
additional fees or bonuses) and produces the same end result. The only
stipulation is that the time intervals are constant although you may have a
zero entry for any time period.
47
The IRR is the most valuable financial tool we have to compare and evaluate
loans and mortgages with differing interest rates, and it is used in Part II and
in the example spreadsheets.
The spreadsheet function is IRR(cash-flow range, guess) where the range
is a list of cells like A1 to A12 (written as A1:A12) that contain the numbers for
which you wish to calculate the IRR. This could be the repayment schedule
for a loan, including interest rate changes and fees.
The guess is optional (assumed to be 10% if omitted) but since the process is
a 20 stage iteration, sometimes the default guess will not produce a final
answer, so it is best to start with as near a guess as possible, particularly for
large or negative answers.
The cash flow range of figures must include at least one positive and one
negative figure, and it must be listed in the correct chronological order. The
examples given earlier in Figures 12 and 13 were calculated using the IRR
function and are replicated in the spreadsheet supplied.
APR Annual Percentage Rate
The formula used to calculate the APR uses the same principles as the IRR
although the assumptions about the term are forced by the legislation, as is
the resulting 1 decimal place rounding and 0.1% variation. The Consumer
Credit Act lays down the fundamental formula for calculating APR, slightly
simplified as follows:-
Loan = Initial Fees + P
1
/ (1 + i)
a
+ P
2
/ (1 + i)
b
+ P
3
/ (1 + i)
c
+
Where P
1,
P
2
etc are the periodic payments and a, b etc are the periods,
usually 1,2 etc up to say 36 for a three year loan. The payments include fees
and costs where relevant, as prescribed by the Act.
The trick is to find i, which is the APR per period, and an iterative solution is
essential. If you assume the periods are months, i will give you the monthly
APR, which is then easily changed to the annual APR with formula
(1 + i)
12
1 where i is the monthly rate.
The iterative procedures used to calculate IRR rely on a formula similar to this
same, fundamental formula. The results for the IRR and the APR are
identical, given the same assumptions and accuracy restrictions.
I would not recommend you use this official formula to calculate the APR in
practice, because the simpler, automatic spreadsheet functions come up with
the same result.
Net Present Value - NPV
This function is similar to IRR and calculates the net present value of a range
of future cash flows, given an interest rate. In other words, what would those
cashflows be worth today to you today if you had a lump sum, instead of the
future stream of incomes and outgoings. It is given by NPV(rate, cash-flow
range) where you enter an assumed fixed rate and the NPV produces a value
equating to the projected cash flows range. If the range is the same as for
the IRR above and the IRR is used as the rate in NPV, the result will be zero.
One can compare and evaluate different cash flows by comparing their Net
Present Values. In some ways, the NPV is easier to visualise and is
particularly useful when evaluating the costs of switching mortgages as is
48
necessary before making a re-mortgage decision. It can be likened to a
cashback calculation. But you must be careful to use the correct, relevant
interest rate assumption.
The next step
We now have at our disposal all the proper tools so we can investigate actual
loan products in some depth. In Part II we look at these real life situations
where interest rates are variable, fees are charged, options are offered and
most importantly, we might have to choose a product from literally thousands
of alternatives.
We will also see how to create wealth by borrowing.
- oOo -
49
50
George Bernard Shaw: Lack of money is the root of all evil
Part II - The Practice
Introduction
The objective of Part II is to apply the science learnt in Part I by applying it to
real schemes, and to enable the reader to have a clear idea on how to
choose a mortgage, and how to exploit a mortgage to make money.
The aim throughout has been to explain fundamental concepts, and to
encourage thinking from first principles so that the reader can go forth as a
wiser person, rather than simply produce an instantly forgettable list of
empirical rules, with little explanation. As a consequence, the book should
not date too much, since the basic principles described can be applied to
more or less any new fangled scheme at least as far as I can predict.
The main aspects discussed in this part are as follows: -
Establish that there are subjective views on which scheme to choose
and it is not all just hard logic.
How to decide whether to buy or rent a home.
Pros & cons of interest-only loans and an explanation of the
endowment mortgage scandal exposed first in 1999.
Identifying different mortgage schemes as groups, such as cashbacks,
discounts, fixed rates, flexible mortgages, with full explanations.
Presenting some criteria for choosing a scheme to suit an individuals
attitude and experience. Introducing a wizard to help you choose.
Having now understood the basic structure of a mortgage, use it to
make money by buying and renting, exploiting the concept of gearing.
For those wanting more, how to use a geared portfolio of commercial
mortgages to make over a million pounds.
The Lenders perspective and how they would design a mortgage.
For the retired homeowner, an overview of Equity Release schemes,
Home Income Plans and Reverse Mortgages.
The Epilogue summarises and peeks into our digital future.
Then there are some Annexes for general interest.
Annex A outlines the birth of the original flexible payment mortgage
concept out of an index-linked mortgage in 1979.
Annex B summarises the still unstable status of mortgage regulation,
including the mortgage code and a summary of CAT standards.
Annex C is a list of the largest thirty lenders as at May 2000.
Annex D lists the spreadsheets included on the disk supplied (or on the
web site).
51
The spreadsheets available from the website are really very useful and easy
to use. I urge even rank beginners to give them a go. At a stroke, you can
then become a mortgage connoisseur, able to analyse many different
scenarios and get instant answers to all your what if questions.
Emotions triumph over intellect
Many years ago, I read a leaflet explaining the art of salesmanship, which
was written for the Chartered Insurance Institute. At one point, it stated, the
emotions are a far more powerful motivator than the intellect. At first, I
thought it was a mistake how can the heart rule the head?
But soon after my early sales experiences, the penny gradually dropped.
People did actually seem to judge a book by its cover, or favour a car by its
colour and prefer clothes in vogue with the latest fashion fad. Whether the
book was a good read, the car was well built or the clothes were functional
was often quite secondary, despite a consumer reticence to admit it.
An early client of mine once listened to my carefully worded, mathematically
correct argument proving (beyond all doubt I thought!) that it was better to
borrow to buy a house and invest her cash separately, especially when tax
relief was at its maximum in those days. She admitted that my proposal was
probably quite correct, but she just did not feel comfortable owing all that
money and much preferred to use her cash to buy the house outright.
The emotions triumphed over the intellect: I was distraught at the time since
she refused the mortgage and even felt good about it. Had the mortgage
interest rate been zero, she might possibly have changed her mind some
deals do have their price. But the moral of the story is that people do not
always decide solely on an objective, mathematical proof: attitudes and
feelings are important too. So while comparative tools are useful, in reality,
the cheapest is not always perceived to be the best. With experience, I later
began to identify some of the reasons behind such emotional concerns and
was able to address them more fully.
Pricing a feeling and separating the logic.
In Part I, for those readers who stuck it out, we looked at some of the basic
tools used to compare the true cost of one loan product compared with
another. In particular, we identified the Internal Rate of Return, or the IRR.
This single, fixed interest rate figure represents the true value of a whole
schedule of varying cash flows, including fees and costs and, more
importantly, when they occur.
We also briefly described the use of the NPV, or Net Present Value, which
calculates value as if you had a single lump sum today, in exchange for a
future stream of varying incomes and outgoings. The NPV can be easier to
visualise in certain situations, particularly when comparing the subjective
features of a mortgage.
The principal use of the IRR and the NPV is as a comparative measure.
Given that we can rely on the rates and figures entered in any loan repayment
schedule, the product with the lowest IRR is the best value-for-money. But
that is not the only story: if we wanted the cheapest form of transport we
would all go to work on scooters. Although you still arrive at the same
destination, the ride may not be all that comfortable, particularly if it rains, so it
may be worth paying extra for a little protection or functionality.
52
Some mortgage products offer more subjective value and therefore might be
worth paying more for in terms of a higher IRR. A flexible payment facility is
very useful to some people; some like the stability of fixed interest rates;
others may prefer capped rates and so on. They may be happy to pay more
provided they know how much more. There remains a need for a value-for-
money analysis so that these more subjective features can then be priced
and compared by using an accurate and consistent measure. You may
prefer, say, a fixed rate mortgage, but is it worth paying an extra 1,000 up-
front for it? Some might say yes, if it meant stable payments. In short, while
the best choice might not always be just the cheapest, we still need to know
the real cost.
For comparing loan products we looked at the new APR (Annual Percentage
Rate) as being a better measure than the older pre-April 2000 APR definition.
But it only measures IRR over the full contractual term, even though most
mortgages finish well before their full term: moreover the APR accuracy rules
are insufficient for a precise comparison, so we still need to use the more
specific IRR for accuracy.
Preliminaries
Ultimately, we all want to know how to select the best mortgage to suit a
particular set of personal circumstances, and such a method will hopefully be
self-evident by the end of Part II. Borrowers may still need help from a
professional adviser, but they will be better able to ask the right questions if
they are better informed. But before looking at the more emotionally related
factors, let alone starting to compare products mathematically, we need to
look at a few other aspects of loans as useful products. Perhaps the most
fundamental question is whether renting is a better alternative to house
purchase?
So we will first be looking for answers to the following questions: -
1. Is it better to rent a house or buy one with a mortgage?
2. What are the advantages and disadvantages of interest-only
mortgages, and what is the so-called endowment mortgage scandal
in the UK all about?
3. What are the various types of mortgage schemes, and how does
one select the best one?
To set the scene, lets first add a few more basic definitions: -
Mortgage Better known as a loan secured on land or property, but
more precisely it is the actual legal deed setting out the
lending terms. A lender can force a sale if you breech
the loan conditions.
Re-mortgage A mortgage that replaces an existing mortgage without
moving house. A re-mortgage can be for a larger amount
than the old mortgage. It is always worth considering a
re-mortgage from time to time to see if you can obtain a
better deal. See the Remortgage spreadsheet.
Loan-to-Value % The LTV is a ratio of the loan to the value of the property,
expressed as a percentage. A 90,000 mortgage
secured on a 100,000 property represents an LTV of
90%. Most lenders limit the maximum LTV to 95% but
53
some will go to 100%, which means no deposit is
required at all. See Indemnity Policy.
Equity The difference between the sale value of the property
and the total of the loan charges, ie mortgages. This is
usually the same as the deposit for a purchase.
Income Multiples Most lenders base the maximum advance that they are
prepared to offer on what they think you can afford. A
commonly used simple rule of thumb is a multiple of your
gross annual income. Typically, many lenders will
consider a loan of up to three times your gross annual
income. If you have a partner joining in the mortgage,
their income can be taken into account as well, although
at a lower multiple.
Affordability As an alternative to using the coarser income multiple
measures, more lenders are now using an affordability
calculation. The maximum loan they think you can afford
depends on factors such as how many children you have,
what your spending habits are and so on. Lenders apply
different models so it is difficult to predict the outcome of
a mortgage application in advance.
Indemnity Policy The higher the LTV, the greater is the risk to the lender of
making a loss, since the equity is smaller. Not only does
smaller equity provide less cover, but also borrowers are
more likely to default, as there is less for them to lose.
Lenders set a maximum LTV, typically 75%, which they
consider normal. Any higher loan can require a lump
sum premium to pay for a mortgage indemnity guarantee
policy (MIG), which covers the excess lent over 75% in
the event of a loss on a forced sale. Most lenders will
allow the premium to be added to the loan.
Some lenders now take the risk themselves, or
alternatively pay the MIG premium themselves. In
fairness, the higher LTV is undoubtedly more risky for the
lender, and borrowers should not be surprised if lenders
charge high LTV borrowers more, in one way or another.
Second Charge Several lenders can take a charge on your property. Any
one of them has a legal right to sell the property if you
have defaulted on their particular loan agreement. The
first lender has the first charge. This means they have
the first pick of the sale proceeds before any other
lender. Lenders can have a 1
st
, 2
nd
or even 3
rd
or more
charge on your property. From the lenders point of view
a second or subsequent charge is less secure as the
prior charge has control. After the 1
st
lender has taken its
due, there may be insufficient money left for any later
lender. As a consequence, interest rates are usually
higher for 2
nd
or more charges. A property with no
charges is referred as unencumbered.
54
Mortgagor The borrower. Note that the borrower still owns the
property and not the lender. Any equity belongs to the
owner, even if the lender forecloses the lender can only
take what it is owed. The owner is responsible for the
upkeep of the property. The lender can only force a sale
through the Courts and only then if there have been
serious arrears or other breaches of the loan agreement.
Mortgagee The lender, who takes out the legal charge on your
property, usually a first charge but sometimes a second
or third charge.
Covenant Most loan agreements insist that you covenant to repay
the loan regardless of any security deficiencies. If your
house sale, forced or otherwise, still leaves a shortfall,
the lender is still entitled to be repaid out of your income
and any other assets you may have.
Redemption Fee Some lenders charge a fee if a mortgage is redeemed
(repaid or settled) earlier than contracted. Most would
waive this fee if the borrower stayed with that lender, and
took out another mortgage at the same time of at least
the same amount. The charge is justified when an initial
discount is offered. Lenders hope to recoup that discount
over a period, and if you redeem early, they rightfully
would wish to charge you for the shortfall. Redemption
fees can also rightly apply when a fixed rate mortgage is
redeemed early to compensate the lender for having to
break its fixed rate contract with third parties.
Some lenders charge a redemption fee even after any
special discount or fixed rate period has expired. This is
often called a tied-in redemption fee. The Office of Fair
Trading (OFT) felt that was unfair, because the lender
could in theory increase the future variable rate to an
unfair figure. Nevertheless, such tie-ins can still be valid
if they mean a better IRR and, if you intend to stay with
the lender in question, the fee is seldom charged anyway.
The OFT assumes that all borrowers need protecting
from unscrupulous lenders, although it would never be in
a lenders long term interests to exploit this situation
otherwise every variable rate borrower would be
vulnerable at all times.
Freehold The legal right to hold land or property as the absolute
outright owner, free of payment or any other duty owed to
another party. As a freeholder, you can then offer to rent
your land or property to parties with whom you'll have a
legal agreement.
Leasehold Holding a 'leasehold' gives you the right of possession,
but not ownership, of a property for an agreed period of
time. Ultimately, ownership remains with the freeholder.
The duration of the right of possession is usually a fixed
55
term granted by the lease. The lease will set out details
of rents and obligations such as repairs etc. Leasehold is
in direct contrast to freehold where ownership is absolute.
Tenant A person or company who rents or leases property for a
short period of time: also called the lessee (the landlord is
the lessor). During that time tenants can occupy the
property as if they were a temporary owner, in exchange
for paying a regular rent. The terms and conditions are
set out in a lease or rental agreement. Most residential
tenancies these days are shorthold and are for terms of
at least 6 months but not often more than 12 months.
Most landlords are now very much more flexible now the
law is generally more supportive of the rented sector.
One can also acquire a property (typically a flat in a
block) on a long leasehold (say 100 years) and pay a
modest ground rent to a landlord: this is virtually the
same as owning the freehold. A long lease however
often includes terms for the upkeep of the common
parts such as gardens, staircases, lifts and so on.
MIRAS Mortgage Interest Relief at Source abolished since 6
th
April 2000. Before that date, successive governments
have subsidised house purchase by allowing tax relief on
mortgage interest. MIRAS did not change the relief, only
the way it was collected: borrowers paid a net figure to
the lender and the lender reclaimed the relief from the
Inland Revenue. Before MIRAS was introduced in the
early 80s you had to claim the tax relief by an adjustment
to your PAYE code.
But governments have gradually eroded the relief (and
how it is applied) over a long period, first restricting it to
basic rate tax, then only on the first 25,000 loan
(subsequently raised to 30,000) and then cutting the
rate of relief down to 10% of the interest up to 30,000
and finally abolishing it.
A mortgage can be an investment
To many people, a mortgage seems to be more of a burden than an
investment and they need a house more for nesting than investing.
Nevertheless, a well-chosen property bought in conjunction with an equally
well-chosen mortgage can prove to be a fine, long term investment. There
are over a hundred different lenders offering a plethora of diverse mortgage
schemes and products and there are thousands of different combinations.
There is no one single best buy for everyone, just as there is no single best
buy product for investors. Much depends on personal attitudes to aspects
like risk and reward. Some people are quite comfortable with a safe and
secure investment return of say 4% pa, and would question the logic of trying
for a 10% return if there was a chance of loosing their capital. Others might
56
say what is the point of accepting a paltry 4% when it is possible to go for
20% - it's a chance worth taking. Either philosophy carries its own lifestyle
risk. A safety first approach may result in a lower, but consistent, standard of
living, whereas a speculative approach might create a millionaire - or a
pauper.
A mortgage considered on its own is a sort of negative investment and the
property it intrinsically supports provides the upside. We need to make the
optimum choice for both components to ensure we get the best value for
money overall.
Fortunately it is possible to set down a method to arrive at your own
personalised "best buy". Once you have some knowledge of the individual
ingredients that make up this best-buy decision, it is then fairly straightforward
to come to your own conclusion.
But before looking at the mortgage schemes themselves in more detail, we
must first consider a fundamental question.
Is buying a house better than renting one?
Everyone needs a home once they have departed their parent's nest; most
people want to build their own nest anyway.
All home hunters have an initial choice between renting and buying. It is
helpful to look at the financial pros and cons of each option to see if one
approach is a better than the other. The short answer is that renting is
probably better for a person likely to want to move within about two years.
Buying a house, with a mortgage, is probably the best bet for the longer term.
Let us see why.
Renting usually requires no more than a months rent as deposit, a regular
rental payment in advance and, depending on the tenancy terms, the landlord
usually looks after major repairs. Renting is straightforward, quick and easy
and can be for short or long term. But the money expended on rent is gone
forever.
Buying your own home usually requires a deposit, some cash for
professional fees and a mortgage. House purchase can be quite a frustrating
process over a period of months. However, houses do tend to increase in
value. They can of course fall in value too, and have done so. But in the long
term, houses have always risen in value, usually in line with wages.
Thirty years ago I remember a colleague saying to me "Buy land - they don't
make it anymore, but they do make more people. A constant supply and
increasing demand mean only one thing - prices go up! Manhattan Island in
America was bought for just $24 in 1626 thats now the whole of New York -
worth probably $24 per square millimetre today!
Well that prophecy has proved right in the long term but it was pretty
uncomfortable for many people when house prices fell continually for 5 years
in the early 1990's. Have a look at the graphs in Figure 14 and 14a, which
illustrate the last 30 years of house prices, wages and inflation.
57
Figure 14
Average UK House Prices, Wages & Inflation 69-99
0
500
1000
1500
2000
2500
1969 1973 1977 1981 1985 1989 1993 1997
Year
I
n
d
e
x
House Prices
Wages
RPI
Figure 14a - Average UK House Prices & Wages 69-99
Adjusted for inflation
80
100
120
140
160
180
200
220
240
260
1969 1973 1977 1981 1985 1989 1993 1997
Year
I
n
d
e
x
House Prices
Wages
One of the causes of the fall in house prices in 1990 was the previous five
years boom. This boom culminated in an almost indecent rush to buy a
house in the late 1980's. Everyone wanted to make money out of the
attractive increases in house prices regardless of personal affordability.
Moreover the government had disclosed that they intended to reduce MIRAS
(Mortgage Interest Relief at Source) for couples unless they obtained their
mortgage before a given date.
This simple indiscretion seeded the frenzy that was to follow, with some
couples buying houses with no forward planning apart from greedy profit
sharing. The following economic recession significantly reduced confidence
in the job market at a time when many wanted to take their profits. People do
not like buying houses when confidence is low. The consequent downward
adjustment in house prices was inevitable.
The depressing house price figures throughout the early 1990s were a
correction of the earlier stampede. A useful statistic to determine the state of
the housing market is the ratio of average house prices to average wage
earnings. In a "normal" economy this ratio is around two and a half to three
58
and a half. In the late 1980's, it rose to five in some regions, indicating that
people were buying houses at almost any cost.
The future of house prices
It is also remarkable how different areas of the UK experienced quite different
growth and decline pictures, each with their own local reasons. See the
House Values spreadsheet for a regional history. But a home is so
fundamental to life that it is likely to remain everyones desire for the
foreseeable future. One might conceive of different community lifestyles in
years to come, but basically everyone needs their own independent space.
The need for homes should ensure that their market value would match what
people can afford. At least, that is the theory, which has operated in practice
for the last 500 years of record keeping.
As our standard of living improves, our capacity to buy a decent house rises
also. Houses are not wasting assets like cars. They last a long time if they
are well built. Property prices tend to increase in line with what we can afford
to buy this is basic supply and demand economics. While the price of new
goods like cars and TVs moves with price inflation, new and second-hand
houses tend to move with wage inflation. In an economically growing society,
wage inflation outstrips price inflation by the economys growth rate.
Therefore property prices should rise by more than inflation in the long term,
and indeed has done so in the past.
So, assuming that property prices are likely to rise over the long term with
perhaps occasional dips, but probably not as dramatic as those in 1990, let us
compare the cost of renting with the cost of buying over a period of say seven
years. The average life of a mortgage is five to seven years, which reflects
peoples need to either move to another job area, or simply to move up the
price range to match their improving income and prospects. Mortgages
seldom last throughout the initial full term, typically 25 years. On the other
hand, tenancies tend to be very much shorter.
The cost of buying compared with renting?
We can compare the overall costs of the two methods and then graph our
findings. I have made the following assumptions: -
Initial house value: 80,000 whether bought or rented.
Increase in house value: 4% per annum on average.
House bought with a 100% mortgage
Mortgage interest rate: 6.25% pa on average over ten years.
Maintenance costs: 2% of initial house value, rising by 2.5% pa
Buying & selling costs: 2% of value on purchase, 3% on sale.
House rented unfurnished
Rent: 6% pa of current property value (rising)
Maintenance: 0.5% of house value, rising by 2.5% pa
Suppose you live in the house for a period of years and then sell it, if you own
it, or simply move out if you rent it. Then add up the total cumulative costs of
each method. Whichever is the lower is assumed to be the cheapest method
overall. If you subtract the total cost of owning from the total cost of renting
and the answer is negative, then renting is cheaper.
59
The graph in Figure 15 illustrates this difference assuming you stay in the
house for the time period indicated and taking into account any profit (after
fees) of selling the house. A negative difference (ie below the x-axis)
indicates that renting is cheaper.
Figure 15
Buy or Rent? Cost difference
Positive figures mean buying is best.
-4000
-2000
0
2000
4000
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Using the given assumptions, renting is obviously cheaper for around two and
a bit years. So if you intend to move in under two years, it may be better to
rent rather than buy, particularly since the expenses of buying and selling are
quite heavy.
But the break-even point depends on the initial assumptions. The rent
assumption of 6% of value is considered low in some areas. An older
property might require more maintenance. Your particular house may rise in
value by more or less than 4% per annum. If the assumption of house price
growth is reduced from 4% to 3% per annum, the breakeven point extends
from two-and-a-bit years to about three-and-a-half years.
Even a 3% per annum increase in house prices might turn out to be
optimistic. Also, inflation is assumed at 2.5% pa - who knows what it might be
in future? The final outcome of just where this break-even point occurs
depends entirely on the input. The Buy or Rent spreadsheet included allows
you to enter all your own assumptions, so you can see your own personalised
graphical comparison and break-even point. But remember the old maxim
about computers: rubbish in - rubbish out!
I have assumed a 100% mortgage (that means no deposit) in the example,
for the sake of simplicity. If, in practice, you assume a deposit of say 10,000
and a lower mortgage of 70,000, you must also accept that the tenant has
the same deposit and would invest it to offset any costs. The effect is not
great, but it is relevant if the return on the deposit differs from the return on
the house.
Rents staircase mortgage payments are flat.
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Despite being able to personalise your buy/rent assumptions, you can still
come to some general conclusions. The most important principle is that rents
are fundamentally linked to the property value, and both are expected to
increase over the years. Rents may not increase gradually. Sometimes they
can be fixed for a year or two and then jump up sometimes areas can go
bad and property values and rents go down, but that is more the exception
than the norm. On average, rent is still related to the value of the landlords
asset and increases over a period like a staircase.
Rent vs Variable Mortgage payment
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Conversely, a mortgage payment is based on a fixed initial debt that cannot
be altered and does not increase over time, assuming you keep up the
repayments. The payments themselves may vary, but the debt is fixed at the
outset. The interest rate might move up or down in line with the economic
situation in general, but the interest payments move in a generally level
direction: rents move upwards and are ultimately related to house prices.
Inflation cheapens debt
Not only is a mortgage a fixed pound-note debt until it is repaid, but inflation
actually cheapens it over time. You effectively borrow expensive pounds but
you pay back with cheaper pounds in the future. The interest rate may
fluctuate, but the mortgage payment burden in real terms is likely to reduce
with inflation. Rent on the other hand is likely to increase with inflation since it
rises with house values, which rise by more than inflation.
If you measure the overall rental payments made by tenants over say a 25
year period, and compare them with the overall mortgage payments someone
might have paid if they had owned the same house, you will find that the
average tenant has paid out more money overall, even Council house
tenants. Moreover, although the tenant may start out with a lower month-by-
month payment than an equivalent mortgage payer, after a period, increasing
rents will overtake the mortgage payments. In short, a tenant will eventually
end up paying more month-by-month and more overall.
The long-term tenant is the ultimate loser
In 25 years time the tenant has nothing to show for his larger outflow,
whereas the owner has a house, and after 25 years, the mortgage could well
be at an end with the house unencumbered. Even if the house has not
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increased in value at all, it is at least worth something, and you thereafter live
in it for free. But the tenant owns nothing, yet has laid out more money.
Furthermore, while the homeowner's mortgage repayments stopped after 25
years, the tenant must continue to pay rent forever - and it will still continue to
increase over time. The property owners may be dead by the time they enjoy
the final proceeds of the sale of the property, but far better to have the choice
to leave some legacy than leave nothing at all, even if it just keeps a cat
happy. Besides, many people would consider moving down to a smaller
home when they retire and use any surplus equity gained on their earlier
homes to put into income-producing investments.
So in the long term, common sense tells you that buying is better than renting
unless you intend to move about a lot. But even then, it pays to buy a house
and rent it to someone else: we talk about buy-to-let later on.
Technical Note
In strictness, for readers of Part I, who now understand the vital concept of
the Internal rate of Return, the graph in Figure 15, showing overall buying
costs and rental costs, should illustrate the IRR or the NPV since when
comparing cash flows, it is timing that is important. This is quite true, but over
the periods in question, the difference between NPV and cumulative costs are
similar. Calculating the NPV would have introduced an unnecessary level of
complication, when all we want is an approximate break-even point. The
assumptions themselves can actually be more wide ranging than the need for
absolute accuracy and purity in the calculation methodology. So I am simply
being a pragmatic engineer rather than a dogmatic mathematician.
Nevertheless, it is interesting to measure the combined IRR effect of buying a
house on a mortgage. Suppose you bought a 50,000 house with a 50,000
mortgage costing you say 330 per month (6.25% pa repayment). If the
house grew by 5% per annum to about 169,300 in 25 years time, the
effective IRR of the investment of 330 pm to produce 169,300 in 25 years
is about 4% pa, ignoring all other costs. So even if the house grows by less
than the mortgage interest, you can still achieve a positive investment return
from buying, and you live rent free as well.
Set of rules for choosing a scheme
Getting back to the plot, remember we are ultimately trying for a set of rules to
help choose one mortgage product. We have now established that for many
people, buying is indeed the best choice, in the long term at any rate. We
now need a mortgage, and what a choice we have - thousands of schemes
with around 100 lenders. Let's look first at the major subdivisions.
Mortgage or Re-mortgage?
Are you moving house or staying put, but changing lenders to get a
better deal? With a remortgage, lenders are more cautious about the
valuation since there is no actual sale to prove the market price. But
the legal fees are lower since there is no conveyance required.
Methods of repayment
Capital repayment or interest-only, or a combination of the two. Often
borrowers have an endowment policy, which was taken out for a
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previous, smaller interest-only mortgage, but is not enough to repay a
larger new loan. But it is possible with some lenders to have a mixed
mortgage, where part is interest-only to match the endowment policy,
and the remaining part is a capital repayment mortgage.
Methods of repaying interest-only loans
An endowment policy, ISA, pension lump sum, unit trust etc. or indeed
no separate investment at all just the house itself.
Fixed or variable interest rates
Usually a fixed interest rate is only for a pre-set period, then changing
to a variable rate or another fixed rate.
Capped, floored or collared interest
A guaranteed maximum interest rate (sometimes coupled with a
minimum) for a pre-set period.
Cashback or Discount
As an incentive, some lenders provide an upfront cash sum or a lower
interest rate for a pre-agreed initial period, such as 3 years.
Flexible Payment
You choose the repayment schedule. In simple terms, you can
overpay and underpay without penalty, but arrangements vary with
different lenders.
Current Account mortgage
A sort of mortgage overdraft, combined with your current bank
account the ultimate flexible payment mortgage. Any occasional
surplus on your account will reduce your total loan and so reduce the
interest charged. You can borrow right up to the agreed limit at any
time, as long as it is repaid at the end of the pre-agreed term. So you
can also use it as an investment account with money going in and out
as you please.
When you put money in, you are saving interest at the full mortgage
rate so your savings are effectively earning interest a much higher rate
than for a conventional deposit and there is no tax to pay either. If
the mortgage rate is say 7%, the deposit rate is 7% too equivalent to
11.67% pa gross for a top rate taxpayer.
Special Cases
For example, this can mean a special focus on impaired credit
applicants (ie those with bad credit histories), or buy-to-let, or elderly
applicants, or non-status, or those wanting 100% mortgages etc.
Shortening the list
With all this choice, where do you start? You need to shorten the lender list.
Decide first if you are moving or buying for the first time, or remortgaging for a
better deal. Then identify if you are a special case and then you can
eliminate lenders who do not offer a product that fits. For example, not every
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lender offers a buy-to-let scheme. If you have had a County Court
Judgement (CCJ) or have been in arrears with your previous lender, you may
not be accepted on normal terms by another lender. Obviously it may be
worth keeping your existing lender in the frame if you are moving house, as
they may prefer the devil they know and give you better terms than any new
lender.
You may now decide to go to a specialist mortgage broker at this stage, now
knowing what questions to ask, or simply search on the Internet or read the
various publications that list practically every lenders products, such as
Money Facts. There are a fast-growing number of web sites that provide
independent tool-sets to search the marketplace. It would be a waste of time
to list all those web sites that are now current, so simply ask your favourite
search engine to locate say mortgages. Try www.find.co.uk, which is a
directory explicitly for financial services.
But there is more to consider before rushing to a broker or to the web.
Interest-only or capital repayment method?
You should also give careful thought as to whether you are going for an
interest-only mortgage or capital repayment mortgage. The capital repayment
mortgage was fully described in Part I, and you will doubtless recall the
various anomalies due primarily to how many rests there are per annum.
However, we can leave that aside for the moment, as in the final analysis of
our short list of products, we will include a calculation of the IRR anyway - the
single figure which can be used to compare any mortgage schedule for the
likely best buy.
An interest-only loan does not require any capital repayment to be made to
the lender until the end of the mortgage or on earlier sale of the property. The
capital is found from either selling the house itself, or from a separate
investment scheme, such as an ISA or an endowment policy. It is not
essential to have a savings scheme to start with. Most people move every six
years or so, and they repay their mortgage out of the house sale proceeds,
hopefully providing a sizable deposit for the next home. Usually a higher
mortgage is negotiated on each move to match ones increased capacity to
borrow. There is obviously a requirement to repay the loan eventually,
probably on retirement, but it is difficult to know what you might eventually
owe at that time.
Interest represents a very significant amount of money, particularly on the
huge loans required for house purchase. So why not repay the loan as early
as possible by using the shortest capital repayment mortgage you can afford?
There is only one reason. If, instead of repaying capital to the lender early,
you can invest it first and achieve a higher percentage return on the
investment than it costs to borrow the capital, it is clearly worth doing, since
you are making money out of well, thin air. This is the essence of gearing
but it requires careful study to understand it properly.
The endowment mortgage scandal
Many people who took out endowment policies to repay their mortgages in
the last decade have been significantly disappointed. To understand this
problem properly, please be patient and follow the steps below: -
1. Understanding the basic anatomy of an interest-only mortgage.
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2. Looking at the past history of the endowment mortgage.
3. Analysing why some endowment policies have not worked out as
promised.
4. What to do about the problem if it has hit you.
We must first understand the basics of an interest-only loan. We will return to
discuss other aspects of the scandal later once we comprehend it better.
Comparing the costs of interest-only with capital repayments
Let's first look at a simple example. Take a 50,000 mortgage with a lender
who charges a nominal 7% pa interest with monthly rests, and for simplicity,
assume the interest rate remains unchanged for 25 years. MIRAS (Mortgage
Interest Relief at Source) no longer operates as from April 2000, so it can be
totally ignored: the gross cost, before tax relief, is now the same as the net
costs.
Payments to the lender per month
25 year repayment mortgage 353.39
Interest-only mortgage 291.67
Difference 61.72
So you pay less to the lender with an interest-only loan, but the capital to
repay the loan at the term end must be saved up from a separate investment
plan. Supposing you take an interest-only mortgage, but invest (in some
monthly investment plan) the 61.72 "saved" by not taking a capital
repayment mortgage.
Payments to lender & investment per month
Interest-only mortgage 291.67
Monthly Investment plan 61.72
Total monthly cost 353.39
We have made the total monthly costs the same as that for a capital
repayment mortgage.
Suppose the investment plan achieves a growth rate of exactly 7% pa,
compounding monthly after any tax and fees, precisely the same rate as the
mortgage interest. What will 61.72 per month for 25 years @ 7% pa
achieve?
The answer, as you probably suspected, is 50,000, exactly sufficient to
repay the loan. The two methods have not only cost the same month by
month, they produce exactly the same end result, accepting some rounding.
Mathematically it is obvious that they would, since the cashflows are identical
and the IRRs are identical.
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Higher or lower growth than the mortgage rate
Now, instead of growing at exactly the same rate as the mortgage, suppose
the investment grew by more, say 8% pa: it would then be worth 58,697 in
25 years time which is a surplus of 8,697 over and above repaying the
mortgage. This surplus has been achieved without having to pay out any
more per month than an equivalent repayment mortgage, so it is a genuine
windfall, tax-free.
But, if the investment only made 6% pa overall, it would mature for only
42,771 leaving a shortfall of 7,229 from the 50,000 needed to repay the
debt - not exactly a good deal. Equally as important, even if the investment
grew by more than 7% pa, but the amount saved each month was insufficient,
you could still not achieve the required amount in 25 years time. This is the
kernel of the endowment mortgage scandal the monthly investment proved
insufficient to even repay the mortgage, let alone provide a surplus.
Compare the IRR
Note also that any surplus or shortfall from the investment is only relevant at
the end of the mortgage, 25 years in this example, when it is eventually
realised. To put this timing aspect into context we can calculate the IRR of
the mortgage taking into account the surplus (or shortfall) from the policy at
the end. These can be done using the Loan Comparator spreadsheet
supplied and entering a negative redemption charge for the surplus. The
lower the IRR the better.
If we work out the IRR for these four cash flows, each with identical month-by-
month costs, it would be as follows: -
Mortgage type & investment rate
(total per month is 353.39)
Surplus in
25 yrs
IRR %
pa
Comments
Repayment mortgage @ 7% pa 0 7.229 % Base
Interest-only + investment @ 7% pa 0 7.229 % No difference
Interest-only + investment @ 8% pa 8,697 6.847 % 0.382% better
Interest-only + investment @ 6% pa - 7,229 7.514 % 0.285% worse
In this example, a 1% pa difference in performance on the investment return
is very roughly equivalent to around a third of a percent off the nominal
interest rate of a repayment mortgage when you look at the deal as a
combination of cash flows.
Compare the NPV
Another way of comparing returns is to look at the equivalent NPV, or Net
Present Value, of the interest-only figures compared with the repayment
mortgage. The table below reflect the same figures as before.
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Type of mortgage & investment rate
(total per month is 353.39)
NPV Comments
Repayment mortgage @ 7% pa 0 Base
Interest-only + investment @ 7% pa 0 No difference
Interest-only + investment @ 8% pa 1,661 Better
Interest-only + investment @ 6% pa -1,181 Worse
So a capital repayment mortgage would have the same value-for-money as
the interest-only + 8% investment provided you also received a 1,161
cashback. Conversely, if the investment made only 6%, it was as if you threw
away 1,181 at inception.
A spreadsheet entitled Investment and Mortgage Calculator is included to
make this mathematical point for any chosen set of circumstances.
Investment returns must exceed mortgage interest
In general, to be worthwhile, an investment set up expressly to repay an
interest-only mortgage must outperform the mortgage interest over the full
term - net of tax and charges. What is the chance of that happening in
practice? How do you go about selecting an investment scheme, particularly
one likely to beat mortgage interest?
Investment choice depends on attitude to risk
There are three investment aims that most people would aspire to: -
1. Safety. You want the investment to be as safe as the Bank of
England. Words like "guarantee" feature highly.
2. Performance. You want it to grow massively by at least 20% a
year, preferably 100% pa!
3. Flexibility. You need to be able to cash it in without penalty at a
minute's notice.
I think it was Woody Allen who said, "Lifes a bitch and then you die".
Financial products are a bit like that. You just cannot have everything you
want in life and you certainly cannot achieve all three of these aims at once,
so compromise is inevitable.
For example, a Building Society deposit scores highly under security - no one
has ever lost a bean in the last 100 years or more from a Building Society
deposit and there is even a government sponsored guarantee for 90% of your
investment up to a maximum figure.
However, you certainly won't get a return of 20% per annum. You would be
lucky to get a return of just under bank rate and then there is income tax to
pay. 4% to 5% pa net might have been just possible in mid 2000 when base
rates were around 6%. Whenever the word guaranteed appears in
investment literature, the performance will always be lower than normal.
Banks and Building Societies obtain the money they lend to their borrowers
from their depositors. The interest rate paid by borrowers must therefore
always exceed the gross return to depositors to cover tax and administration
expenses, at least in the long term. So it is obvious that in terms of beating
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mortgage interest, safe deposit type investments are non-starters its just
structurally impossible.
Nevertheless, you would be able to cash in most deposit accounts very
quickly, so such deposits are flexible as separate investments. When
measuring up a deposit type investment with our three Aims, aims one
(Safety) and three (Flexibility) score high but aim two (Performance) scores
badly.
Conversely, investing in stocks and shares can provide very high potential
performance but not much in the Safety department. Over a long period of
time, a portfolio of shares has not only beaten inflation, but by a good margin.
But, as they say in the advertisements, shares can go up and down and the
past is not necessarily a guide to the future.
Property in general, including commercial property such as offices, shops,
and warehouses has also proved to be a good investment in the long term
and is probably safer than stocks and shares, certainly less turbulent.
However, you can't cash in a house as quickly as a share. You can't cash in a
part of a house either. Consequently, property scores low on Flexibility but
its not so bad on Performance and less risky than shares in general.
Conservative investments are no good for mortgage repayments
Unfortunately, the safest investments are clearly unsuitable to repay a
mortgage since the return is more or less guaranteed to under perform to
mortgage interest.
To recap, the criterion for an effective interest-only mortgage is that the net
return from the investment must exceed the gross mortgage interest over the
full term. For example, to match a 7% pa average long-term mortgage rate,
you need a gross investment return of at least 8.75% pa to cover basic rate
tax before any charges are considered. In practice, you probably want at
least a 1% pa better return than the mortgage rate to make the effort and risk
worthwhile, so you are most likely looking at 10% per annum minimum gross
return for a taxed fund after charges, or 8% pa for a tax free fund. Where are
you likely to find an investment to achieve that with any reliability?
Put another way, is it worth the risk just to achieve a third of a percent
reduction in your overall effective mortgage rate?
Cautious people choose repayment mortgages
The answer depends on your attitude to risk. If you are risk adverse then
there is no point in choosing a safe investment alongside an interest-only
mortgage since it will never work out. So for security conscious people, a
capital repayment mortgage is the safest of all since there is no investment to
risk.
On the other hand, if you are happy to invest in more speculative equity
funds, which, over the long term, could well produce above average
performance, then an interest-only mortgage is worth considering alongside
an investment in equities or property.
The past is not necessarily a guide to the future
An endowment policy used to be an excellent way of repaying a mortgage,
and life insurance was built in, unlike a repayment mortgage when it was an
extra cost. What changed? There were three main sorts of policy: -
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1. Full with-profit endowment. This is where the insurance company
guarantees to pay out the initial sum assured at maturity regardless of
intervening performance. Bonuses (an amount added to the final
maturity value of the policy to reflect the performance of the insurance
company and its underlying investments) were added annually which,
once added, could not be removed, so the investment only got better,
never worse. The monthly premium on such a policy was quite
expensive: with the mortgage interest as well, the overall monthly
mortgage costs was prohibitive for most first-time purchasers. Not
many people took them out.
2. Low-cost endowment. To reduce the monthly premium, insurance
companies roughly halved the size of endowment policy. A 50,000
mortgage needed only a 25,000 full endowment policy
(approximately, depending on the mortgage term) assuming that future
bonuses should be sufficient to cover the initial shortfall by the end of
the term, judging by the past.
Importantly, this required a projection of future bonuses yet to be paid
and so which were not guaranteed at outset. An extra element of life
insurance was added in to ensure the full loan was paid if you died at
any time during the mortgage. With its lower premium, the overall
monthly cost of the mortgage, including the interest, was now similar to
that of a repayment mortgage, after MIRAS.
3. Unit-linked endowment. The premium is invested directly into one or
more of many different specific funds, equities (UK and overseas),
property, gilts or even cash. The policyholder may switch from one
fund to another at any time. This concept, in theory, enables the
investor to choose between strategies of being adventurous or
cautious by simply selecting the appropriate funds. In practice, you
need to know what you are doing to make it effective and clearly no
performance guarantees are available. Life insurance is also included.
The monthly premium is higher than a low-cost endowment but not as
high as a full endowment.
The low-cost endowment became a best seller. The projected returns
provided by the insurance company even predicted a surplus at the end of the
mortgage. It was seen to be a no-brainer, since if the monthly costs were the
same or lower and you got a bonus too, why have a repayment mortgage?
And because it was based on the with-profits principle, it seemed to be very
safe. The full life cover and the words with-profits encouraged people to
think it was a full endowment, forgetting it was actually only half the size.
What went wrong? The answer lies in the bonus rates used to project the
estimated maturity figures and the consequent premium calculation. After a
decade of high inflation, the bonuses rose to record levels: equity based
funds (stocks & shares and property) were always expected to out-perform
inflation given enough time, and indeed they did. Even with-profits funds
invest in some equities. But the higher the bonus projection, the lower the
premium required on the policy to repay the mortgage. In the event, many
over confident companies quoted too low a premium.
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Falling Bonus Rates
When inflation started to fall in the 1990s, so did the expected returns on
equities, and so bonus rates dropped too. Insurance companies found it
difficult to advertise a lower bonus and many retained their projections at
unrealistically high levels. The consequence, as time moved on, was that it
became increasingly clear that the low monthly premiums, set when bonuses
where projected at higher rates, were just not sufficient to even repay the
mortgage, let alone provide a surplus.
The brokers and salesmen were not entirely to blame. Whilst some salesmen
failed to highlight the lack of a guarantee, the life insurance companies
themselves provided the future projections, and they also calculated the
premiums. Life insurance companies were always thought to be
conservative institutions, so it was not unreasonable to assume that there
were sufficient hidden reserves to match their heady projections. Sadly, for
many companies, this was untrue.
Scandal
Sales-led insurance companies, in a highly competitive market, just could not
bring themselves to bring the bonus rate projections down and the premiums
up. Worse still, the regulatory authorities at the time accepted that the
projections that were being made were reasonable. Even the press failed to
identify the seeds of scandal until it was too late. The companies eventually
had to write to their policyholders and admit that their premiums were
insufficient to repay the mortgage. The saga was and still is a travesty, it need
not have happened had product providers projected with more care, and that
is why the word scandal applies.
Moreover, even if the premium was increased to a level sufficient to repay the
loan, the overall net return for the more conservative endowments is now
unlikely to be sufficient to make a with-profits endowment mortgage
worthwhile, because mortgage tax relief had gradually disappeared.
Ironically, with-profits endowment policies on their own can, and do produce
reasonably good returns. But if they are used specifically to repay an interest-
only loan, the return still may not beat the net (now the same as gross)
mortgage rate because their fundamental design is too conservative.
Tax relief in the past
The most important current scenario change has been loss of tax relief on
mortgage interest. In the early 1970's, when I was starting out as a mortgage
broker, you could get up to 83% tax relief on mortgage interest. If the
mortgage interest rate was 10% pa gross, it only cost an effective 1.7% pa
because 83% of it was subsidised by the taxpayer.
In the 1970's, an endowment policy also enjoyed tax relief on the premiums,
tax privileged status on its internal funds and tax-free maturity benefits. For
an investment to improve on a net mortgage interest rate of only 1.7% pa was
just no contest. It was crazy not to have an endowment mortgage in those
days, particularly for the higher rate taxpayer. Ironically, life insurance
premium relief (LAPR as it was called and was once some 17.5 % of the
premiums) was introduced to encourage the less well-off to take out life
insurance. In practice, it enabled the richer cognoscenti to exploit the rules to
their significant benefit.
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To further compound the advantages of home ownership in those days,
mortgages were particularly worth having during inflationary times, such as
the double-digit inflation experienced during the 1970's and some of the
1980's as well. You could actually borrow money at a net rate of interest
substantially lower than even the inflation rate.
Even if you simply bought goods with the borrowed money you made a profit.
Since you were enjoying tax relief, the net borrowing rate was effectively only
around 6% pa for a standard rate taxpayer, but inflation was running at
around 20% pa, so you were making 14% pa just by borrowing the money
and spending it! In other words you could buy something for 100 on
borrowed money and you could repay 106 in a year's time @ 6% net
interest. The same goods would have cost 120 the following year because
of inflation, but had you tried to save 100 @ 6%, the resultant 106 would
never be enough! There was never any point in saving if the net return is less
than the inflation rate.
When you buy a house with borrowed money, you have purchased a real
asset, that is to say, one intrinsically linked to the inflationary process, like
equities. The house would appreciate eventually by more than the already
high inflation rate but since the debt is untouched by inflation, the equity rose
significantly. Furthermore, when you sell your own home there is no capital
gains tax to pay and you have lived rent-free in the meantime - you can't live
in a share certificate. The adage in those days was to borrow today's
expensive pounds and pay back with tomorrow's cheap ones; get the
largest, longest, cheapest mortgage you can afford.
In summary, for the mortgaged homeowner in the 70' and 80's, it was win, win
all the way to the bank: win on the low net mortgage rates, win on the
endowment mortgage gearing, win on house prices and more win on inflation
which shrunk the mortgage debt. It was no surprise that MIRAS was
eventually phased out and life insurance premium relief was removed. The
tax payer was subsidising an activity which was profitable enough without any
subsidy being necessary. The changes were not sudden but gradual.
Moreover, endowment mortgage sales had already gained such a high
momentum that it was difficult to reverse a conceptual idea that had been
perfectly valid for decades earlier.
But what a shame that the previously so conservative life insurance industry
let down their customers, and their salespeople, so badly in the last decade
by simply not quoting realistically conservative premiums, and by not
recognising the obvious signs for the demise of the with-profits endowment
method as mortgage tax relief slowly sank into oblivion. They should have
known better.
Do you have an under-performing with-profits endowment policy?
If you have received a letter from your insurance company to say that your
policy might not have sufficient funds to repay your mortgage at maturity, as
many people have, independent advice is recommended before taking any
action. If you have had bad advice you may be able to claim compensation.
But both the borrower and the adviser could consider the following points: -
1. Establish the size & scope of the problem what is the likely shortfall
at the end of the term? How long to go?
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2. If you intend to move house before the mortgage ends, you could
simply do nothing, since the house sale will repay the mortgage. Your
next mortgage can then be a different type.
3. Surrendering the policy early is not a good idea as the value-for-money
is poor; if you really have to, selling the policy will produce a higher
figure using one of the many specialist agents.
4. Increasing the premiums may be a bad idea as you are simply
compounding the problem, depending on the projected performance
from today. But ask what the realistic growth rate of the policy from
now would be (as a % pa after tax and charges or, better still, an IRR).
If you really believe this might out-perform your projected mortgage
rate, it may then be worth increasing the premium.
5. Switching the policy to a better performing scheme such as a unit-
linked endowment or an ISA may improve the performance albeit at an
increased risk.
6. Converting your mortgage to a repayment is probably possible, but the
monthly costs will inevitably rise. Converting it in full would
immediately take away any risk. The endowment policy, regardless of
the maturity value, then becomes a separate savings scheme and life
insurance policy.
7. You may consider a part repayment and part endowment mortgage
effectively only converting the shortfall into a repayment mortgage.
This is probably the cheapest option but you still need to be sure that
the policy will still perform for the reduced endowment part.
8. In either of the last two options, consider extending the term of the
repayment mortgage part.
The Future
In the year 2000 it seems we are set for lowish inflation for the foreseeable
future, possibly lower interest rates as well, and house prices rising. There
has already been a mini housing boom, which may well be followed by a
minor downward correction in some regions, mirroring what happened a
decade previously but hopefully not so sharp.
There is now no longer any tax relief at all on residential mortgage interest,
unless it is used to buy an investment property, when it can be offset against
rental income. Any investment used alongside an interest-only mortgage
must now make a net return of more than the gross cost of borrowing a
harder target. But if the investment fund is itself tax exempt, there is a much
better chance of the arrangement working. However, as we have proved, it
cannot be a safe investment, since by definition, it is designed not to beat
gross mortgage interest.
The Individual Savings Account - ISA
There are two main investment products that currently remain tax privileged.
One is a pension scheme and the other is an ISA. The ISA is the most
flexible, and you can choose a range of equities to invest into. For those with
an attitude that accepts risk as part of life, the combination of tax exemption
and the ability to speculate over the long term in stocks and shares to
maximise growth, makes the ISA (and its forerunner, the PEP) ideal as a
mortgage repayment vehicle.
72
In the past, equity based funds (eg stocks and shares) have always had the
best chance of good performance in the longer term this is exactly matches
the sort of term one needs to save to repay a mortgage. Although you may
move house and even switch lenders, you can still use the same, growing ISA
each move, increasing the contribution where you can, subject to the
government imposed maximum.
If for some reason the theory changes, say the government re-imposes tax on
the underlying funds, as they did with pension funds, you can simply cash in
the investment, revert to a repayment mortgage and knock off some of the
outstanding debt at the same time.
Often, retirement means you buy a cheaper house to release funds to
augment income, so a restructuring at that point is inevitable. When you get
near to retirement, you can switch the ISA funds to something less risky. If
you retire when the fund values are down, you could apply to extend your
loan or convert it to a repayment mortgage.
If you can afford it, you can have a repayment mortgage and an ISA as well.
This may mean belt and braces and a lower overall gain but a significantly
lower risk; at least the mortgage will be repaid and it is only the profit on the
ISA which is dependent on performance. Another compromise is a repayment
mortgage but a more modest contribution into the ISA.
The simple spreadsheet Investment and Mortgage Calculator provides a
guide as to what sort of contribution is needed to repay a loan at any time in
future, given your own estimate of growth rates. It is important to remember
that past investment performance measured over a period of inflation (like the
last 25 years performance of an endowment policy) is totally irrelevant when
projecting over a more modest inflationary period.
Life Insurance
Unit-linked endowment policies do have certain aspects going for them.
Unlike conventional with-profits endowments, they invest directly in a chosen
range of equities an even more extensive choice of speculative equities and
property funds than an ISA. These life insurance funds are taxed at only
standard rates and are therefore tax privileged for the higher rate taxpayer.
Also the life insurance is built in if you died during the mortgage term, the
mortgage is paid off.
If you took out a repayment mortgage and needed the same protection
against premature death, you would need to take out a separate policy, albeit
a cheap term policy. Depending on your age and habits, this might add costs
the equivalent of around a half to one percent pa of the loan. The life
insurance costs within an endowment policy are lower than for a separate
term policy. One reason for this is that the amount actually at risk is falling
as the investment builds up. There is no such reserve in a term policy, and
the running expenses of even a cheap policy are little different to the
expensive, but perhaps better value for money, endowment policy.
For the avoidance of doubt, I am referring here to unit-linked endowments as
opposed to the classic with-profits endowment policies. While with-profits
policies are capable of producing reasonable returns, their conservative
investment strategy means they have a lower chance of beating the mortgage
rate than a unit linked investment. That is not to say they wont, as much of
their fund is equity and property based and the returns usually beat deposits
73
and life insurance is included. But ironically, because you need to speculate
a bit more to validate the interest-only mortgage concept, the with profits
policy might be just too secure.
Pension schemes
Pension funds linked to equities and property are more likely to out-perform
mortgage rates in the long term because of the tax-breaks they enjoy. The
higher your marginal tax rate, the better deal they become, since the state
provides tax-relief on your contribution. Moreover, there is no internal tax to
pay apart from dividend income and then only at standard rates. A good
proportion of the fund is also available as a tax-free lump sum.
But the prime object of a pension scheme is to provide income in retirement.
It cannot do two jobs pay off your mortgage and provide a pension without
one or the other suffering as a result. While in theory a pension lump sum is
mathematically likely to be a better deal when used to repay a mortgage, in
practice the ISA is far more flexible, as you can get hold of the cash at any
time. This decision may well be a matter of personal choice.
Term and Life
Remember that the monthly cost of a capital repayment mortgage depends
on the initial maximum term agreed with the lender the longer the term, the
lower the repayment. But the life of the loan may well be much less as few
borrowers stick to the same initial mortgage for the whole term, However
most borrowers cannot afford the higher payments required for a shorter
term, which is why most terms are over 20 years, even 35 years in some
cases, although the actual mortgage life is nearer five or six years.
The monthly interest costs for an interest-only mortgage are the same
regardless of the term. But the savings scheme is term dependent the
longer the term, the lower the monthly savings required.
Since borrowers selecting a repayment mortgage expect to pay it off as soon
as possible, they should pick the shortest term they can afford, whereas
interest-only borrowers expect to profit from the mortgage, so they would want
the largest, longest mortgage.
Interest-only summary
In summary, your attitude to investment risk will dictate whether or not you
should take an interest-only mortgage. The method can produce better value
than a repayment mortgage but only if you are prepared to take a risk. The
risk is lessened if you invest long term and in tax privileged funds, but you
cannot pursue a conservative strategy. An ISA, a unit-linked endowment, and
possibly a pension fund, all equity linked, would all be suitable candidates.
But you really should know what you are doing and professional advice for the
amateur is essential, at least in the early days.
If you do decide to go for an interest-only loan, you might as well make the
term for as long as possible perhaps up to your retirement date. If you are
going to make some extra money on the investment you need the largest,
longest loan you can get. On the other hand, a repayment mortgage is best
repaid over as short a time as you can comfortably afford.
- oOo -
74
75
The Mortgage Products
At this point in the story you may have decided to buy and not rent, and you
have also decided between an interest-only loan and a repayment mortgage,
depending on your attitude to risk. If you chose an interest-only mortgage,
you must also decide on the investment scheme. You have eliminated the
lenders who cannot help with any special status and it is now time to consider
the products themselves.
Incentives and redemption penalties
Most lenders now offer initial incentives to buy their products, particularly for
the first time purchaser. Lenders still need to balance their books: the
interest they receive from their borrowers must go to pay their depositors and
cover all the administrative expenses as well. Market forces ensure that
depositors can get the best possible deal, so lenders must be creative in
attracting borrowers.
Typically these incentives take the form of either a cashback, an initial tax-
free cash lump sum, or a lower initial interest rate (a discounted rate) for a
specified period. Obviously a lender cannot afford to subsidise the early
years of a mortgage in this way unless there is a compensating payback later
on.
Any early incentives must be paid for out of the longer-term interest that the
lender charges for the remaining life of the mortgage. If borrowers want to
jump ship and settle early before those early incentives are paid for, they will
be charged a redemption fee. It is not a penalty, as that word implies an
excessive payment. For most lenders it is a compensatory payment.
The interesting point about such fees is that most lenders will waive the fee if
you move house and simply take another mortgage of at least the same
amount on with the same lender the new house. This is called portability. If
you are happy to stick with your lender, it enables you to ignore redemption
penalties. You might say that redemption fees are then optional.
In some cases redemption fees remain after any discounting period has
finished. While this is perfectly valid mathematically, and indeed necessary
with a cashback, the regulatory authorities dislike such tie-ins. They suspect
that lenders may take advantage of borrowers tied in to a so-called variable
rate by increasing it beyond the norm. In practice, this would be very unlikely
as the whole point of the exercise is to attract borrowers with low, continuous
rates. An exploitative lender would soon be spotted and penalised by losing
custom. That is the normal way market forces operate.
Lenders want you to stay with them for as long as possible. It is an expensive
exercise to gain a new customer for any business. Once gained, it makes
sense, for both sides, to keep that customer happy. Having said that,
customers remain promiscuous and loyalty in the end is only a matter of
money. As a result, wise lenders will ensure that departing customers do not
produce a loss.
Nevertheless, it is well worthwhile measuring the IRR to the point when there
are no redemption penalties, typically 5 years or more. The APR, which
assumes the loan runs for the full term, which mortgages seldom do, is not an
appropriate measure. Once you are in a free redemption fee period, you will
then have the opportunity of remortgaging (sometimes even with the same
76
lender) if there is a better product with a lower IRR than the IRR for staying
put. The software for making these vital calculations is on the Re-mortgage
spreadsheet.
The table below illustrates a typical example of a lenders discounted
offerings, assuming a 50,000 interest-only mortgage with an on-going
variable rate of 7.50% pa, compounding monthly, and ignoring any fees. The
discount is expressed as, for example, 2.50% discount for the first 12
months, which means the initial 12 months chargeable interest rate is the
normal variable rate less 2.50% ie 5.00% pa. If the variable rate moves up
by 1% the discounted rate also moves up by 1% to 6.00% pa.
Discount
period
Initial nominal
rate % pa
Eventual
standard rate
IRR over six
years
Equivalent
cashback
12 months 5.00 % 7.50 % 7.237 % pa 1,204
24 months 6.00 % 7.50 % 7.154% pa 1,397
36 months 6.50 % 7.50 % 7.174% pa 1,350
48 months 6.75 % 7.50 % 7.193% pa 1,306
The cashback is the alternative amount that can be paid initially but with the
charging rate at the variable rate of 7.50% pa throughout. It has been
calculated here to produce the same IRR as the discount, both measured
over a 6 year period. Monthly rests are assumed.
Many newspapers quote the initial interest rate only, and order their table
with the lowest first. You can see why that is misleading, since the best deal
is this example is clearly the 6% for 24 months scheme, which has the
lowest IRR, or the highest cashback. Some lenders charge a very low initial
rate, just to lead the table, but can then have a higher-than-average standard
variable rate or compulsory insurances or a high redemption charge.
Cashback or discount?
When should you take a cashback and when should you take a discounted
rate? The first step is to compare the IRR, so use the Loan Comparator
spreadsheet or the on-line tool. If the calculations work out to be roughly the
same (which they should if the lender has done its sums correctly), it is
immaterial which scheme is chosen as far as value-for-money is concerned,
so consider the following.
Take the cashback if you need to spend more money on the house, such as
furnishings or home improvements generally.
Take the discount if your income might be a bit strained for a period. The
reduced burden for a year or two might get you past the point when you get a
pay rise. The term of the discount should cover the period of anticipated
income-squeeze.
If the IRRs differ, clearly the scheme with the lower IRR is the one to go for
unless you have a particularly overwhelming need for initial cash regardless
of the IRR.
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Interestingly, repayment mortgages score a slightly better on IRR than
interest-only mortgages when initial incentives are involved. This is because
by the time the higher on-going rates kick in, the amount owing on a
repayment loan is slightly lower, as some capital has been repaid. Most
lenders ignore this anomaly but for borrowers, choosing the repayment
method in these cases will win them a little extra bonus. Experimentation with
the Loan Comparator spreadsheet will illustrate this. The table below
illustrates the differences between identical discounts and cashback
equivalents for the interest-only and a 20 year capital repayment method.
The standard variable rate is 7.5% pa in each case, with monthly rests.
Discounted rate Interest only Capital repayment
and initial term IRR (6 yrs) Cashback IRR (6 yrs) Cashback
5.00% for 12 mths 7.237 % pa 1,204 7.202 % pa 1,196
6.00% for 24 mths 7.154% pa 1,397 7.121% pa 1,372
6.50% for 36 mths 7.174% pa 1,350 7.145% pa 1,309
6.75% for 48 mths 7.193% pa 1,306 7.177% pa 1,250
The difference is more marked the shorter the repayment mortgage term: the
term makes no difference to an interest-only mortgage. Also note that some
lenders offer a small cashback as well as an initial interest rate discount.
Fixed interest rates
A fixed interest rate mortgage provides the borrower with the comfort of a
stable repayment schedule over the fixed rate term. In America fixed rate
terms of 30 years are commonplace, whereas over here we are lucky to find a
ten year fixed rate although a few lenders are starting to offer long term fixed
rates. In most cases a fixed rate is only for a set period of a few years,
typically two to five years, with a redemption fee for early settlement.
The main attraction is the fixed payment schedule rather than an attempt to
get better value-for-money. Most UK lenders combine the fixed rate offering
with a discount as well, so the true underlying fixed rate is often camouflaged.
But you should expect to pay a little more for the added benefit of stable
payments. There is another way of stabilising payments, which we will look at
later, and where there are no early redemption fees.
Fixed rate schemes cost money
Most lenders raise money from short term, variable rate depositors. A lender
offering a fixed rate to a borrower and matching it with a variable rate
depositor is clearly taking a risk. Interest rates could rise, increasing the
payout to depositors with no corresponding increase from the borrowers who
have been promised no change: lenders could be seriously out of pocket and
even go bust if the mismatch was bad. This actually happened in the USA
during the last century forcing the government to step in with massive rescue
schemes.
These days, the risk taken by lenders offering fixed rate loans is hedged.
That is to say, they buy a financial instrument called a swap, which effectively
78
passes the risk on to a speculator, usually a large institution like a bank. The
speculators take a professional gamble on future interest rates. If rates move
as they think, they will win out and they lose if not. On the whole, as
professionals, they win more than they lose. So if a lender offers a fixed rate
of say 6% (ignoring incentive discounts), the professionals think that market
rates on average will actually be lower than 6% over the term in question.
This means that most underlying fixed rates usually turn out more expensive
than accepting the fluctuating series of variable rates over the same period.
In other words the IRR for a fixed rate scheme will usually turn out to be
higher. But in return, the borrower is enjoying the comfort of a fixed, stable
payment schedule, which must be worth something.
In the USA fixed rates are the norm and borrowers expect them to be more
expensive than ARMs Adjustable Rate Mortgages as they call them. If you
want something extra, it usually costs money and fixed rates provide security
and security costs. But it may still be worth it, depending on your attitude.
The professional probably knows best
To hope that a humble borrower will outsmart the professional speculator
requires an element of immodesty. That is not to say it never happens.
Some fixed rates have turned out to be winners for the borrower. But on
average they turn out to be winners for the speculator. The speculator is not
necessarily the same as the lender who has paid someone else to lay off the
bet. But if you as a borrower want to come out of a fixed rate contract early,
be prepared to pay a fee, which reflects the additional cost to the lender of
breaking his contract. It is not a case of the lender profiteering from a penalty
but compensating from a real cost, at least in most cases it is.
Whenever the press reports rising interest rates, borrowers think they should
now fix their rates. But, the lenders will already have adjusted the rate they
offer to match the expectation. Only if a lender happens to have an old
tranche of funds, hedged when rates were perceived to be lower, is it possibly
a value-for-money exercise.
In summary, choose a fixed rate more for its payment stability rather than an
attempt to beat the City at its own game. Those with a conservative attitude
towards investment might well be candidates for a fixed rate repayment
mortgage. But do not expect a fixed rate scheme to deliver better value-for-
money: there is a cost to pay for fixed, stable payments.
Interest rates quoted for both fixed and variable rates themselves change
daily. An example of what fixed rate was possible on 2
nd
June 2000 is shown
in the table following, when 3 month LIBOR was 6.26% pa. LIBOR stands for
the London Interbank Offered Rate and is the lowest rate banks can borrow at
often called the wholesale cost of money - for a set period. Wholesale
lenders will be able to borrow at this rate plus a small margin, and then lend
out at the same rate plus a bigger margin and call it the Standard Variable
Rate. Fixed rates are obtained in a similar way but most lenders then apply a
discount incentive as seen in the table below, assuming a margin of 1.25%
and an incentive discount of about 5% in year one.
Term in years Fixed rate
base cost
Typical full
fixed rate
Typical fixed
discounted rate
79
1 6.68 % pa 7.93 % pa 3.00% pa
2 6.65 % pa 7.90 % pa 5.50% pa
3 6.67 % pa 7.92 % pa 6.25% pa
4 6.63 % pa 7.88 % pa 6.50% pa
5 6.57 % pa 7.82 % pa 6.75% pa
10 6.33 % pa 7.58 % pa 6.95% pa
Caps, floors and collars
There are many different financial instruments available to creative lenders to
enable them to offer special products. The fixed rate product is funded with
swaps. But it is also possible to obtain a capped rate using a similar
instrument. To the borrower, this means that the interest rate charged
couldnt exceed the capped rate over whatever term it is capped for, but it can
fall if interest rates generally fall. On the face of it, it seems an excellent idea
to the borrower a safety margin if things go bad, without losing the option of
lower rates if they occur, although there is an early redemption fee.
However, like the fixed rate, there is always an extra cost whenever extra
security is built in. A capped rate would normally be higher than a fixed rate
since the speculator behind it has less opportunity to make a profit. If it is
security and stability you need, a capped rate is unnecessary since the fixed
rate provides it more cheaply.
But when you look at floors, things become more interesting. A floor is when
the interest rate can go no lower than a prescribed rate. A lender would pay
you if you agreed to a floor. If you wanted a cap and a floor, the cost of the
two might even cancel out, depending on the rate range you chose. Such an
arrangement is called a collar. It is like a fixed rate scheme but which can
move in a preset range like a snake in a tunnel.
However, the most desirable collars, which provide the best protection against
perceived rate rises, but some comfort when rates fall, are still usually
available at a net cost. They may be attractive to some people: it is always
best to calculate the IRR and NPV as described earlier to compare the
scheme with other products and to identify just what you are paying for the
security privileges. Only then can you judge if the facilities are worthwhile.
Use the Loan Comparator spreadsheet for this purpose.
Flexible payments
In the early 80s, my company, Mortgage Systems Limited, was responsible
for introducing the original concept of the low start, flexible repayment
mortgage, a derivative of the unique index-linked mortgage. The story for
those interested is included in Annex A.
The essence of a flexible payment mortgage is the ability of borrowers to vary
their payments, up and down, to suit changing circumstances. Any unpaid
interest is added to the loan. If you have a repayment mortgage, you would
probably like to repay the capital as fast as you can afford. A flexible
mortgage enables you to do this on an ad hoc basis, for example, using an
occasional windfall to knock off some of the mortgage debt. But more
80
importantly, you can take back any earlier overpayments should you need to;
perhaps to buy a new car, or to fund general living expenses.
In some cases, lenders might allow a repayment holiday when you pay
nothing for a short period to perhaps help when you are between jobs or are
ill and cannot work.
There is now a growing list of lenders offering these basic facilities, all with
differing terms. If there are no additional administration charges made for
over or under payments, the IRR will always work out the same. If you
overpay, you will save interest; if you underpay, the debt will grow with unpaid
interest. But the interest is charged at the same effective rate.
Variable income borrowers
If you are self-employed with variable income expectancy, a flexi-payment
mortgage may be suitable provided you understand the way the scheme
operates and are prepared to spend a little time managing your mortgage
account.
One would naturally expect the IRR for a flexible mortgage to be higher than a
conventional mortgage, since it offers desirable extra features. As before, the
value of any such extras is put into context by comparing the IRR and NPV
with an alternative product using the Loan Comparator spreadsheet. There
is also a Flexible Mortgage spreadsheet included as a generic example of
what is possible.
Stabilising payments with a flexible mortgage
One attractive use of a flexible payment mortgage is as a D.I.Y. (Do-it-
Yourself) fixed rate scheme. Suppose your Flexible Mortgage variable
interest rate was currently 7% pa, but you could actually afford to make
monthly payments as if the rate was 7.2% pa. You could then keep those
payments fixed, and as long as the actual interest rate charged stayed
below 7.2%, you could maintain fixed payments for as long as you like. But in
the meantime, you would be repaying some capital, so accelerating the time
when the mortgage finishes altogether. Alternatively, you could use this fat
to ensure no increase in your payment is necessary even when variable rates
exceed 7.2% for a period.
You have effectively achieved the best of both worlds a stabilised payment
schedule but without paying for a formal fixed rate scheme and still profiting in
full from rate drops. And no early redemption fee!
The table below illustrates the first ten years of a typical interest-only flexible
mortgage of 100,000 at variable interest rates, but assuming a stable
payment of 600 per month - equivalent to 7.2% pa. In practice the loan has
fallen by about 3,000 in ten years. If the rate was a genuine fixed rate of
7.2%, the debt would still have been 100,000, and there would have been an
early redemption fee.
81
Year Actual
Interest % pa
Normal
Pmt pm
Minimum
Pmt pm
Actual
Pmt pm
Debt
Yr End
1 7.00 583.33 583.33 600 99,793
2 6.00 500.00 482.22 600 98,547
3 5.00 416.67 292.29 600 96,222
4 9.00 750.00 419.58 600 97,743
5 8.50 708.33 511.51 600 98,896
6 8.00 666.67 570.62 600 99,634
7 7.00 583.33 551.68 600 99,401
8 7.00 583.33 531.52 600 99,151
9 6.00 500.00 426.96 600 97,865
10 6.50 541.67 357.46 600 97,001
And so on
After year one, because of the overpayment, the minimum payment that you
could pay if you wanted, is lower than the normal payment (ie without a
flexible facility), because you have built up some fat, which has reduced the
capital owing, although the lender has agreed to your maximum debt being
100,000 throughout, until the last year.
If you have been overpaying like this for several years, there will be sufficient
fat to cope with an interest rate change of more than 7.2% pa for a short
period, as illustrated in years four, five and six.
It is up to you to choose the effective payment rate at which to stabilise your
payments the higher the rate, the less likely it is to change, and the quicker
the loan is repaid. The IRR is the same whatever schedule you choose,
unless the lender makes additional charges for each change.
The graph below illustrates the whole twenty-five year term, showing how it is
possible to reduce the payment at any time. After ten years, the interest rate
is assumed to increase somewhat, so necessitating a payment increase.
Without the flexible payment facility, the normal monthly payment would
fluctuate much more in line with actual interest rate movements, as can be
seen with the dashed line on the graph below.
Incidentally, at the time of writing, lenders still differ on the flexible features
they allow. The best ones allow you to borrow back overpayments at any
time, allow payment holidays and account for daily interest. There should be
no additional fee for payment variations and you should be able to view
statements and vary payments via the Internet. Check before you commit.
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Flexible Mortgage - Stabilised Payments
0
250
500
750
1,000
1,250
1 3 5 7 9 11 13 15 17 19 21 23 25
Year
P
a
y
m
e
n
t
Actual Minimum Possible Normal Payment
In summary, a stabilised (but flexible) schedule is ideal for the conservative
borrower but whos knowledge is good enough to understand the implications:
it may also turn out to be better value-for-money than a fixed, capped or
collared rate as there are no guarantees to be underwritten. Some lenders
operate the stabilised repayment feature without the need to trigger a
minimum payment. Instead they accept a flexible full redemption period or
final amount owing: this is not expected to be significantly different to the
normal period. In any event most mortgages terminate before their scheduled
full term anyway by either a sale or a changed loan.
Increasing payments with a flexible mortgage
Most people could afford to pay more each month in the future than today.
Today is always more expensive than tomorrow your partner has given
up work, you have kids to feed, furniture to buy, HP to settle, family holidays
to pay for and so on. But the future gets easier. The kids leave home, your
spouse goes back to work, you get a pay rise, even if it just keeps pace with
inflation, and the HP is paid off so paying for a mortgage gets easier over
time until the divorce that is!
For those wanting to repay a loan as fast as they can afford, they probably
have a capital repayment mortgage anyway, but with a flexible mortgage you
can accelerate payments at any time. So one schedule that might appeal is
the increasing repayment mortgage. If you increase your monthly
repayments every twelve months by 5% per annum, a 25 year mortgage @
7% pa could be paid off in just under fourteen years, saving you thousands of
pounds in interest payments: the saving is about 42,000 for a 100,000
loan.
Moreover, you are not committed to the excess payments. You have the
choice at any time to revert to a lower level of repayments, and you can re-
borrow any surplus capital you had repaid earlier, although a few lenders do
not allow this important facility, so its worth checking.
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In short, for borrowers who dont mind spending some time on their financial
affairs, the flexible payment concept is almost Utopia.
The graph following illustrates a twenty-five year 100,000 loan at 7% per
annum throughout, finishing at year fourteen with payments increasing by 5%
per annum.
Flexible Mortgage- repayments increasing
by 5%pa
0
500
1,000
1,500
2,000
2,500
3,000
1 3 5 7 9 11 13 15 17 19 21 23 25
Year
P
a
y
m
e
n
t
Actual Pmt Level Pmt MinimumPmt
A general-purpose example of the principle of flexible payments can be found
in the Flexible Mortgages spreadsheet.
Current Account Mortgages
One of the principles of good financial planning is that it is not sensible to
have both loans and investments in the medium term, unless you hope the
investment will outperform any loan interest. If it doesnt, then you might as
use the investment to pay off the loan, as you will save money instantly.
It always surprises me to see so many people with building society or bank
deposits earning them paltry interest rates, when they owe their credit card
company money, which costs them interest of over 20% in some cases. It is
clearly more sensible to repay the credit card loan with the deposit, unless the
deposit is for a special, short-term reason.
Virgin One first offered the current account mortgage in the UK, although
other lenders claim to have similar schemes. It is a flexible mortgage scheme
run from a current bank account. It is like having a cheap overdraft on
guaranteed terms. The only stipulations are that the loan must not exceed
the pre-agreed maximum and it must be repaid (by any method) by the end of
the pre-agreed term. In between time, you can take money out or put money
in however you like: interest is calculated daily. The reserve is the amount
you could draw on if you wished.
A current account mortgage will provide the facility of managing your quick
access savings as well as all your loans mortgage or credit card. When
your pay comes in at the end of the month, it is used to immediately reduce
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your mortgage debt, albeit perhaps for a week or two only. The effective
deposit rate of interest is the same as the mortgage rate. If you borrow at
7% pa, your deposit will earn 7% - tax free, equivalent to 8.75% pa gross for
a basic rate (20%) taxpayer, or 11.67% pa gross for a 40% taxpayer. It is
impossible to get a better deposit rate that the equivalent of the interest rate
on your debt.
If everyone did this, there would be no conventional deposits left from a large
cohort of borrowers: the banks would lose the turn they otherwise make on
the difference between the deposit and the lending rates. If this idea was
rolled out to everyone, it could be costly for the banks, unless they increase
the lending rate, which they probably would. Moreover, there is an
administration cost to such lenders, which must be covered by the lending
rate.
Evaluating current account mortgages
It is very difficult to evaluate this type of loan. The IRR and the quoted APR
are usually a bit higher than normal schemes, but it is only when you use the
investment facility that it becomes worthwhile. Borrowers who are unlikely to
be able to exploit this facility may be better off with a flexible mortgage.
You can look at it this way. Suppose you normally use a deposit account and
also expect to receive investment interest on your current account too. First
evaluate the likely interest you would conventionally earn overall, in say a
year. Say this came to 1,000.
If your savings pattern remained the same, you would obviously earn a higher
effective investment rate if you switched to a current account mortgage, say
1,500. So you could save 500 each year in this example.
If your mortgage was 50,000, this 500 saving is approximately equivalent to
a 1% pa rate reduction. I must stress that this is a simple example, with
deliberately simple figures. Every individual will have a different profile, and it
requires a personal calculation. The savings effect reduction must then be
offset by any loading, or higher mortgage rate charged by current account
lenders, compared with an alternative, competitive mortgage product.
As another way of looking at a current account mortgage, imagine you borrow
50,000. But because you deposit say 5,000 on average each month, due
to your monthly pay, or from transferring from other lower-interest deposits,
you pay interest on only 45,000 10% less.
There is always the risk that the projected pattern of savings does not actually
arise and that any potential is not actually realised in the future. But if used
correctly, and with some more competing lenders in the field to keep the rates
competitive, this mortgage method has much to commend it, particularly if it
can be managed over the Internet.
A Current Account mortgage is more or less automatic once it is set up as far
as offsets with income are concerned, whereas a Flexible Mortgage that is
separate from your bank account may need regular action on your part.
Special status loans
Some borrowers have had difficulty with credit: they may have arrears with
current lenders and even a CCJ or a County Court Judgement over a debt.
Every lender performs a credit search on every applicant, and so these details
will be known to them.
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It is a fact of life that borrowers who have to be taken to Court to satisfy a
debt, are unpopular with lenders, since their attitude to debt is subject to
doubt. This may or may not be true for individual applicants. Nevertheless,
many lenders will not accept applications from those with CCJs.
But there are a number of specialist lenders who will consider such
applicants. They will almost certainly charge a higher interest rate and will
only lend on a lower LTV Loan-to-Value percentage. Lenders differ as to
what other references are taken. Some lenders rely only on the property as
security, lending say 65% maximum LTV. If the loan is not repaid on time,
the lender can foreclose and make a good return on the higher interest rates
charged. There are clearly risks to this sort of lending and it is fair that the
interest charge is higher.
Paragon Mortgages offer this type of loan (Year 2000) but where the initial
interest rate premium falls away after a set number of years of scheduled
payments without arrears: this is a fresh-start type of loan where borrowers
who have suffered from problems in the past will not be penalised for ever.
It is still possible to select the best value-for-money deals using the IRR or the
NPV but only among the lenders who specialise in this market niche.
Self-Certification
Some people find it difficult to prove their income for a variety of reasons, one
of which is a simple need for privacy. More normal, is the businessman
whose accounts may not totally represent his income. Such applicants can
access a few lenders who allow borrowers to state (self-certify) their income
without the need for double-checking.
Clearly there will be an extra cost to this type of loan in terms of higher
interest rates, commensurate with the added risk of arrears. As with impaired
status loans, the lender in this case is relying more on the property to repay
the loan than your income: the maximum LTV is therefore likely to be lower
as well.
100% loans
For borrowers with no deposit a few lenders will offer 100% LTV loans, but at
a higher interest rates. It is occasionally worthwhile obtaining a lower rate
loan at say 95% LTV and borrowing the balance from elsewhere, even your
own bank. You effectively have two loans at different interest rates.
To check this out, work out the melded rate from both sources as follows.
M = (L
1
x I
1
+ L
2
x I
2
) / (L
1
+ L
2
)
where L
1
and L
2
are the two loans at interest rates of I
1
and I
2
respectively.
Now enter the M, the melded rate in to the Loan Comparator spreadsheet
as if it was one product to compare it with any other.
Buy-to-Let
This is another specialist area where a mortgage is required to purchase a
property not to live in, but to rent out to someone else. There is a longer
section later on, which explains the special attractions of this sector.
There are a number of lenders who specialise in buy-to-let and, as with the
impaired credit lenders, it is just as valid to apply the IRR and NPV
measurements to those schemes as with any more conventional mortgage.
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Compulsory insurance
Some lenders only offer what looks like a cheap interest rate provided you
take out buildings and contents insurance or mortgage payment protection
insurance through their agency. This is a valid method of marketing, although
the authorities dislike it since they imagine consumers can be easily duped
although not now they have read this book.
Lenders gain commission from additional insurance policies they sell, and if
they can offset some of this extra income against an interest rate reduction, it
could still work out a good deal for the borrower, who still needs to take out
the insurance with someone anyway.
To check this out in the Loan Comparator spreadsheet, you will need to enter
the monthly premium. In strictness, you should only enter the extra premium
you would pay, above what you would pay by going elsewhere, if at all. You
can also compare two schemes with different insurance premiums.
The APR rules do not require buildings insurance to be included as part of the
credit costs, even if it is compulsory, but they do require compulsory payment
protection insurance to be included. So while the accurate IRR payment can
be based on any extra premiums you wish to include, the APR illustrated by
the lender may be legally accurate, but possibly misleading as only the
statutory extras are included.
General features of lenders
There are some other features of the lenders themselves that are worth
considering before making a final choice between those at the top of your
final list. Lenders fall into the following main categories: -
Mutual Building Societies
Building societies, such as the Nationwide (at the time of writing), are
owned by their members, without external shareholders. The
advantage could be better rates for borrowers and investors, since all
the profits are distributed to members and so, in theory, margins are
smaller. On the other hand, they are denied some of the freedom of
banks to enter other markets. The 68 or so remaining building
societies are regulated by the Building Society Commission under the
legal framework of the Building Societies Act.
Bank plcs
Most banks are owned by external shareholders and are supervised by
the Bank of England. Banks can compete in broader markets denied
the more restricted building societies. Many of the old Mutuals are
changing to banks because of pressure from their members to obtain
windfall cash on the conversion. Whilst banks have to make profit and
pay dividends and so in theory operate with wider margins, they can,
again in theory, profit from other diverse areas to offset that margin
pressure. Listed companies are also under greater incentive to
compete and to maintain efficiency.
Specialist
A few firms have been set up as specialist lenders and are often
funded exclusively from wholesale money markets and have no retail
depositors. Paragon is one example, who specialise in buy-to-let, and
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Kensington is another who specialise in impaired credit lending. As
with any publicly owned enterprise, market forces encourage
efficiency. With no retail deposit base to administer, in theory, margins
can be narrowed and lending rates kept competitive.
Other specialist organisations perform specific services, such as
product design, marketing and packaging application from brokers and
borrowers and administering third party mortgage portfolios. They are
not themselves lenders, but assist lenders by focusing on service
areas they do well. My old company, Mortgage Systems Ltd, was such
a company and is now called Homeloans Management Ltd.
Clearly specialist lenders or organisations attract borrowers with specific
needs. But for a straightforward mortgage application, a mutual lender may
be able to offer a better deal, since they operate on thinner margins and there
is always a chance of a windfall as well if they succumb to conversion.
How to pick a mortgage scheme - summary
We have now discussed a wide variety of mortgage concepts. While you are
ultimately searching for the one mortgage product that offers the best
financial value-for-money, as measured by the IRR, there are other factors
affecting your final scheme choice that depends on personal circumstances
and attitudes.
From our earlier investigation, we now know when an interest-only mortgage
is worthwhile, who would pick a fixed rate and who would pick a variable rate.
You recognise that your personal choice depends on your attitude to risk and
your awareness of financial planning in general.
So, by way of summary, here is a short question and answer session, which
might help guide you to your personal, optimum scheme choice. This
Mortgage Wizard is also available as an included spreadsheet.
The preliminaries
Before answering the main questions, check out the following:
Buy or Rent?
Before deciding on a house purchase mortgage at all, be sure you are
better off buying than renting. If you are likely to move within two
years, renting may turn out better value for money, depending on the
growth of house prices. See the Buy or Let spreadsheet to satisfy
yourself.
Mortgage or Re-mortgage
Are you looking for a re-mortgage? This is required if you are not
moving house, but have an existing mortgage, and you wish to switch
to a better deal with a new lender or even the same lender, often
increasing the loan at the same time. In this case, use the
Remortgage spreadsheet to enter your current loan details to
ascertain the cost of switching mortgage.
Credit History
Some lenders will not lend to you if you have an impaired credit history,
such as a CCJ (County Court Judgement) or have arrears with other
lenders. Fortunately there are some lenders who specialise in
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lending to those with an impaired credit history. If you have had any
credit or arrears problems in the last 6 years, you will need to disclose
this to your selected lender: all lenders perform a credit check before
lending, so they will find out anyway. If they are not prepared to offer
you a mortgage, seek out a specialist lender, if necessary, enlisting the
help of a specialist mortgage adviser.
Now please answer the following questions. In each case, the reasoning
behind the question is stated first.
Question 1 Income & Job
In general, employed people enjoy a more stable income than self-
employed people. Those with less regular income might well be
attracted to flexible payment features. Those with stable income might
prefer fixed rate loans or level flexible payment loans. Those with
increasing income might favour discounted rate schemes.
Which is correct?
11. My income is fairly reliable and stable.
12. My income varies and is not always predictable.
Write down the answer, either 11 or 12.
Question 2 Attitude to Financial Management
Some people just want a simple, worry-free mortgage, whereas others
might want to get that little bit extra out of their finances, using more
sophisticated arrangements.
Which paragraph best describes you?
21. Low Awareness. Not really interested in investment or
financial planning matters. Know very little about it. Just want
the simplest, best deal.
22. Medium Awareness. Know a little bit about investment and try
to keep my financial affairs organised. Prepared to involve
myself in my finances when I have the time.
23. High Awareness. Very interested in investments and financial
planning, and spend some time in ensuring my affairs are in the
best possible order.
Write down 21 or 22 or 23.
Question 3 Attitude to Financial Risk
Attitude to risk affects choice in a number of ways. Conservative
people might prefer fixed payments, minimum sized loans and capital
repayment mortgages that finish as soon as possible. More
adventurous people may prefer to take their chance with variable
interest rates, maximum sized loans and interest-only loans repaid by
ISAs, and flexible payments. Some may go for a combination of
factors.
Which paragraph best describes you?
31. Conservative. Cautious. Minimise risk wherever possible,
even if it meant taking a lower return. Would probably not buy
shares directly.
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32. Realistic. Accept that occasional small risks are sometimes
necessary to achieve better returns. Might consider an ISA
investment.
33. Adventurous. Speculative on occasions. Recognise that high
rewards come from taking high risks, and is prepared to take
such risks.
Answer 31 or 32 or 33.
So now you should have written down three numbers, eg 11, 22, 32. From
the following table, write down the paragraphs that relate to your answers.
Think of a comma as reading and, so 11, 21 means answer 11 and
answer 21.
Answer Paragraph number
11 (stable income) and:
21, 31 (low, conservative): 1a, 2a,
21, 32 (low, realistic): 1a, 2a
21, 33 (low adventurous): 1a, 2a or 2c(i) or (iii)
22, 31 (medium, conservative): 1a, 2a
22, 32 (medium, realistic): 1a, 2c(i) or (iii), 3
22, 33 (medium, adventurous): 1b, 2c(i) or (iii), 3
23, 31 (high, conservative): 1a, 2a or 2b
23, 32 (high, realistic): 1b, 2c(i) or (iii), 3
23, 33 (high, adventurous): 1b, 2c(i) or (iii), 3
12 (variable income) and:
21, 31 (low, conservative): 1a, 2a
21, 32 (low, realistic): 1a, 2c(ii)
21, 33 (low adventurous): 1a, 2c(ii)
22, 31 (medium, conservative): 1a, 2a
22, 32 (medium, realistic): 1a, 2c(ii), 3
22, 33 (medium, adventurous): 1b, 2c(ii), 3
23, 31 (high, conservative): 1a, 2a or 2b
23, 32 (high, realistic): 1b, 2c(ii), 3
23, 33 (high, adventurous): 1b, 2c(ii), 3
Write down your results paragraphs, eg 1a, 2c(i) or 2c(ii), 3, and then
consult the relevant paragraphs below, which now summarise the scheme
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that should be particularly applicable to you. You can also read those
paragraphs that may not have applied to you, which may cause you to re-
think your attitudes. Please remember that this is only a suggested guide and
is not meant to replace a full fact-find of the type obtained by independent
advisers.
Results Paragraphs
1. Method of Repayment
a) Capital repayment mortgage
Monthly repayments include both capital and interest to the
lender so the loan is gradually repaid over the mortgage term:
the shorter the term, the higher the repayments.
If you select a capital repayment mortgage, you might want only
the lowest loan you need to make a purchase, with the shortest
term you can afford, allowing some leeway for possible future
interest rate increases. In general, the planned mortgage term
should finish before your planned retirement date. In practice,
many people move house every 5 to 7 years. This means, for a
repayment mortgage, you can easily re-jig the loan at every
move.
b) Interest-only
You pay interest only to the lender so the monthly payment is
the same irrespective of the mortgage term. The capital debt is
repaid at the end of the term with the proceeds of a separate
investment plan, which is built up from regular payments.
This method is only financially worthwhile if the overall return on
the investment, after tax and charges, exceeds the overall
interest rate charged on the mortgage. This is unlikely to
happen if you choose a conservative investment plan. But it
could be worthwhile if you invested sufficient monthly payments
into tax-privileged funds linked to shares, such as ISAs. Those
with a conservative attitude to investment might be better off
with a repayment mortgage.
Those selecting an interest-only mortgage might want the
largest loan possible, and to keep it going as long as possible,
up to retirement date. The longer the term, the lower the
monthly investment needed and the better chance the
investment has of outperforming the mortgage interest, which is
the objective of the interest-only method.
2. Schemes
a) Fixed rate
Some lenders will guarantee a fixed interest rate for an agreed
period of time. The main advantage is a stable payment
schedule for that period, regardless of what happens to interest
rates generally. After the initial fixed rate period, the loan
reverts to either a variable or a new fixed rate.
But lenders need to protect themselves should underlying
interest rates move up, when they would lose out. This
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protection costs money. So the overall value-for-money,
compared with using a variable rate mortgage, might be higher,
but you have bought peace of mind. Should you terminate the
mortgage early, there is normally a redemption fee payable,
usually waived if the loan is continued with another property.
Fixed rates should not really be used to out-guess the market.
Lenders know more about the future of interest rates than the
borrower: they are therefore more likely to quote rates on which
they will win, rather than lose but you could be lucky.
Bargains are also occasionally available from old tranches,
which were raised before new rate trends were established.
Many lenders also include a discount on a fixed rate loan as an
incentive to make it more attractive. This camouflages the real
fixed rate component, which makes these schemes harder to
compare.
b) Caps, Floors & Collars
Caps and Collars are in the same family as fixed rates. A few
lenders will cap an interest rate, so you know it cannot go higher
than the specified rate, but it could change to a lower variable
rate if interest rates fell generally. As with fixed rates, this
added peace of mind costs money, and a capped rate is usually
higher than a fixed or collared rate: an early redemption fee is
payable, unless you take the loan with you if you move house.
A collar is similar to fixed rate range, a rate which can move up
or down within a preset maximum of a cap and a minimum floor
like a snake in a tunnel. The narrower the range the lower the
cap and the higher the floor, until they both ultimately approach
the same value as a fixed rate.
If you are simply looking for stable payments, a straightforward
fixed rate will provide that, without the need for capping or
collaring.
c) Variable rates
A standard variable interest rate will move up and down during
the mortgage term, broadly in line with interest rates in the
economy as a whole. In the long run, lenders have to ensure
that their lending rates cover the interest paid to their depositors
and to cover expenses. Standard variable rates usually work
out at about 1% to 2% above bank rates in general: some
lenders even guarantee a bank rate link, say 1% over bank rate.
Lenders also offer incentives, which can typically be
cashbacks, discounted rates for an agreed period or a
combination of both. Some lenders will offer a lower variable
rate throughout, with no initial incentives.
Such initial incentives almost always come with early
redemption fees, but most lenders waive these fees if you move
house and continue with the same, or a higher mortgage. The
main types are: -
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i) Cashback
A tax-free lump sum payable at, or soon after completion:
ideal for those whose capital resources are stretched and
who would welcome some extra cash for furniture or such
like. This scheme is also probably easier to manage than
a discounted rate, given equal value-for-money, since the
monthly payment is level thereafter subject to future rate
changes.
ii) Discount
A reduced interest rate for a specified number of years,
sometimes changing in more than one step. A lower
payment for a year or so is useful for those whose
income is stretched initially, but who expect
improvements later on. Be sure you do not get too used
to the lower payment. The initial discount period to select
depends on when you think your income will improve.
iii) Lifetime discount
This is not really an initial incentive but a straightforward
level payment loan: the interest remains as low as
possible throughout the mortgage, often with a
guaranteed margin over a specified base rate or a
promise to beat other specified rates. This scheme
sometimes offers better long-term value than a cashback.
Since there is no initial discount, there is seldom a
redemption fee, so you can settle up at any time.
3. Flexible payment (including current account mortgages)
There are a growing number of schemes where you can choose your
own payment schedule. You can pay in, or take out random lump
sums and can take occasional payment holidays, if there is a sufficient
reserve, and there is normally no early redemption fee.
For those on variable incomes, such as the self-employed, this type of
scheme may be particularly useful. There is also the added attraction
of D.I.Y. mortgage management, for those interested enough, by
setting your own payment schedule. For example, you can accelerate
the termination of your mortgage by simply paying more each month:
you might aim to increase your payment every year.
You could also have a D.I.Y. fixed rate by paying as if you were on a
fixed rate schedule, assuming it is at a higher rate that the prevailing
normal variable rate. But, unlike a real fixed rate, any such over-
payment will repay a proportion of your mortgage. Note that most
flexible lenders do not offer a formal fixed interest rate option, as there
is no need, and so most are variable rate.
Scheme Choice Summary
Hopefully you should now have a better understanding of which scheme and
method of repayment matches what type of borrower. Attitudes are important
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but features such as extra security and flexibility come with a higher price or
less flexibility if an early redemption fee is included. Having decided on the
scheme, the measurement of which actual lender is simply down to a
measurement of the lowest IRR, remembering that future interest rate
projections can only be guesses.
Use the Loan Comparator spreadsheet for this purpose, or insist your
adviser does, to sort out the true value of so-called incentives and the other
costs of a mortgage. If you are re-mortgaging, use the Remortgage
spreadsheet to identify the cash value of a switch.
Finally, if you chose an interest-only mortgage, use the Investment and
Mortgage spreadsheet to understand how the investment must perform to be
worthwhile.
Now you know a bit about mortgages, the next two sections will explain how
you can use a mortgage to create wealth using the concept of gearing.
- oOo -
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Buy-to-Let and the Magic of Gearing
One of the earliest scientific dreams was the perpetual motion machine; a
theoretically continuous source of energy with no input ever being required.
Perpetual motion is of course physically impossible, although it is easy to
design a near utopian machine, which utilises the earth's abundances of free
resources such as sun, wind and wave energy.
Our ancestors made particular use of a simple device called the lever. It
enabled almost impossibly large weights to be raised with little effort by using
a long pole with a fulcrum near the heavy end. The same effect can be
achieved with pulleys or gears.
Interestingly, it is possible to devise a moneymaking machine that can
apparently achieve a greater effect than the effort required and that can also
mysteriously double or triple investment returns. The concept is called
gearing or, for American readers, leverage, usually with the "lever" part
pronounced to rhyme with "clever".
An easy example of gearing for buy-to-let properties
Say you had 10,000 to invest. You buy a 100,000 house using a 90,000
mortgage, so your initial 10,000 is the deposit. Ignore fees and costs for the
moment.
Assume the house was let out and the rental income just covered the interest-
only mortgage payments, so the ownership cost was zero - again forget
maintenance costs for the time being.
Finally, let us say the house was sold for 105,000 a year later, which
represented a property growth rate of 5% pa. After repaying the 90,000
interest-only mortgage, you are therefore left with 15,000. Your profit is
5,000, which is the amount left over after the sale less your original capital
investment of 10,000.
Capital growth enhanced
In summary, you have invested 10,000 and after one year received 15,000
- a profit of 50%. But the underlying asset itself, the house, only appreciated
by 5%. You have achieved an actual return on capital of ten times the
underlying asset growth. The IRR (Internal Rate of Return) of your
investment is 50% pa. Had you bought the house for cash with no mortgage,
the IRR would be only 5% pa. This remarkable result arises as a direct result
of gearing. You have geared up by a multiple of ten to increase a return of
5% to 50%, simply by borrowing.
Income yield enhanced
Now let us move one stage further. We first assumed there was no net
income since the rent equalled the mortgage interest. But say the property
was actually rented out for 7,300 per annum (about 140 per week) - that's a
modest property yield of 7.3% pa and is easily accomplished in many areas of
the UK.
If the 90,000 mortgage interest rate were 7% pa, the interest payable in the
year would come to 6,300. Income 7,300, expenditure 6,300: the result
is a net income of 1,000 per annum.
An income of 1,000 per annum on an initial investment of 10,000 means a
running income yield of 10% per annum. So, not only have you achieved a
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capital growth of 50% but there is also an income of 10% per annum as well -
an IRR of 60% in total in year one!
Is this really true? Surely it is not that easy. What are the snags? Well,
reality always involves some friction, which also frustrated the perpetual
motion machine from realising perfect success. But despite some setbacks,
the results from gearing can still be impressive.
The key to understanding gearing is to base your yield calculations on the
actual capital invested, the deposit if you like, and not on the value of the
house. It is only then that your calculations come to life. The investment
income yield is the rental income divided by the capital invested expressed as
a percentage. The property yield is the rental income divided by the value of
the property only. The IRR is the total return including capital growth.
Friction reduces returns but does not eliminate them.
In the first example, we ignored costs and the effect of tax. Taking "friction"
(ie all the costs) into account will inevitably bring down the eventual return.
Say there is an additional 500 per annum to pay each year to cover
maintenance and the general expenses of running the property. This brings
the running income yield down to 500 pa - from 10% pa to 5% pa.
The expenses on the purchase and the sale of the property could well absorb
much of the first year's profit, leaving only say 1,000 surplus out of the gross
5,000. But even 1,000 is 10% of the 10,000 invested.
After just one year, adding in the running yield of 5% pa, the IRR is now a
more humble 15% pa gross, less than the dramatic 60% frictionless return
from our first example but still three times bigger than the underlying 5%
growth of the asset, so gearing still multiplies the return.
Tax
Income tax must be paid on any revenue profit, which is your rental income
less any relevant expenditure. Mortgage interest counts as relevant
expenditure so tax is levied only on your 500 pa profit. Your net income is
the gross income less tax at your marginal tax rate. A top rate 40% taxpayer
would pay 200 tax pa, reducing the net income to 300 pa - a 3% pa net-of-
tax running yield.
Capital gains tax is also due on the capital profit less acquisition costs and
selling costs. If the gain was just 1,000, capital gains tax at the maximum
rate of 40% could whittle this gain down to a net 600, although many
taxpayers would pay less tax, if any at all, if their total gains are lower than the
annual allowance and taper relief is available over time.
With your net income of 200 and the 600 net capital gain, the eventual
outcome from your 10,000 investment is 900 in total after all tax and
expenses - possibly more if your tax rate is lower. This is a 9% net-of-
everything profit in one year. A 40% taxpayer would be lucky to get 3.6% pa
net of tax from a conventional deposit, so gearing has at least doubled, and
could possibly triple the underlying growth rate. And we have only considered
one year and absorbed all the initial expenses.
Buying & selling costs
The buying costs should strictly come out of the initial investment and the
selling costs from the sale. Realistically, one needs to hold the property for at
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least two years to produce a return that exceeds that which could be achieved
by paying cash, to cover the buying and selling expenses. The Buy-to-let
spreadsheet included allows you to enter any set of variables. In particular, it
compares the overall return both with and without gearing (ie paying cash) to
highlight the advantages of gearing when relevant.
Risk of loss
Suppose the property fell in value by 5% instead of increasing in value,
producing a 5,000 loss. You will still have costs to pay as well, so you could
lose most of your initial 10,000.
Similarly, if the mortgage interest increased by more than the rent there could
be a negative running yield - even more negative if the tenant leaves or goes
into arrears. Voids in rental income are commonplace and must be expected.
So obviously the downside with gearing of this type is the risk of loss. As we
have identified earlier, higher returns always imply higher risk. The higher the
gearing, the greater the risk of loss - but the more exciting the gain if it all
works out. Administration costs could well turn out to be more than expected.
Minimising the risk
The figures in the above example assumed a sale after just a year to keep the
figures simple. In practice one would want to hold the property for a bit longer
and in particular resist selling if the market is depressed. As we have seen
earlier, property prices can fluctuate, although the general trend is very likely
to be upwards.
Mortgage interest can fluctuate but fixed interest deals are available as we
have seen and are particularly appropriate for the nervous investor.
A smaller mortgage can reduce the risk as it increases the running income
although it reduces the yield since you have to put down more capital. The
ratio of the mortgage loan divided by the property value is known as the LTV
(loan-to-value percentage). The last example assumed a high LTV of 90%.
The higher the LTV, the higher the running yield and the greater the potential
capital return, but the higher the risk of both losing the capital and suffering a
negative income over time.
Mortgage
(LTV%)
Initial
Investmen
t
Gross
Income pa
Yield % pa
50,000 (50%) 50,000 3,800 7.6%
70,000 (70%) 30,000 2,400 8.0%
90,000 (90%) 10,000 1,000 10.0%
Individual investors can therefore address their own perception of the balance
between risk and reward by choosing the most appropriate LTV. In most
cases it is down to what deposit is available. An ideal balance of risk against
reward might be an LTV of between 70% and 80% and most lenders would
not lend more than 80% anyway as they like to see the rental income
covering the mortgage interest by a comfortable margin. But ultimately it is
down to individuals, their cash situation and their attitude to risk.
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The property yield will also affect the choice of LTV. In some areas property
can be rented for yields of well over 10%. The best yields often come from
the smaller, cheaper properties costing well under 100,000 and not situated
in up-market areas. But higher yielding properties often grow by less and visa
versa. The careful investor who chooses well could achieve a geared return
well into double figures and 20% pa is quite possible.
Safety in numbers
For the serious, professional investor, it can be worthwhile buying a portfolio
of properties. There is always an advantage in the economy of scale, since
expenses can be distributed and the risk is spread. There is less likelihood of
a void (ie no tenant) being so serious when you have a few other performing
properties to bolster the income.
If you had 100,000 available to invest, you could buy one property for
100,000 for cash and enjoy a good rental income with low risk but a modest
capital gain. Or you could buy ten similar properties with high gearing and
achieve two or three times the return and with a higher running income than if
you paid cash. But the risk, albeit on the higher side, is significantly lessened
with the "safety in numbers" strategy.
A successful example of buy-to-let
A colleague of mine manages a portfolio of 35 flats in the West Country
distributed over seven separate properties with five or six flats in each. Each
flat fetches from 70 to 90 per week producing around 100,000 per annum
gross income, allowing for 10% voids - so 3 or 4 flats may be unoccupied at
any point in time. He is using some surplus income to refurbish some of the
flats in order to improve chance of earning a higher future rent.
He invested initially about 200,000 and borrowed 500,000 from the
Nationwide Building Society to buy the 700,000 portfolio, which initially
yielded around 15% pa running income, based on the property values alone.
The average LTV was just over 70%.
After mortgage interest, maintenance, refurbishment and management costs,
he enjoys around 40,000 per annum income before tax, which represents
20% pa running yield on the 200,000 investment. The portfolio now, about
15 months later, is probably worth at least 800,000, which represents a
capital profit, when sold, of 100,000 on an investment of just 200,000 -
50% in 15 months. Not bad!
Clearly he bought well and at a good time and luckily had a decent chunk of
capital to start with. But it demonstrates the sort of exciting returns that are
possible, in spite of "friction".
Commercial property
Many would-be landlords baulk at the prospect of finding and managing even
one tenant let alone several dozen. There are many Agencies who will, for a
fee, take on the burden for you. But for the investor with a sizable deposit of
more than 100,000 and who wants to minimise the hassle, there is another
alternative - the commercial property.
I am talking about offices, warehouses or even factories, let on a commercial
tenancy basis. The concept of gearing described for buy-to-let residential
properties is still equally valid. The difference is that commercial rents are
usually for a longer period (5 to 20 years or more as opposed to a 6 month
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shorthold) and the tenant is usually responsible for repairs and insurance.
Moreover, a good quality commercial tenant is far less likely to default and the
rent usually rolls in every quarter with little aggravation.
Quality covenants
Like residential tenants, the quality of the tenant, in terms of their likelihood of
paying the rent regularly, is critical. In commercial terms, it is referred to as
the "strength of the covenant". A good quality covenant may mean a blue
chip public listed company like a bank or an insurance company, or a well
known high street store like Boots or Woolworths, or one of the numerous
government bodies. They are very unlikely to default and they also like the
comfort of a long-term contract.
The downside is that the property yield for such good quality tenants may be
lower than that for the less illustrious occupant. Nevertheless it is possible
(Year 2000) to obtain property yields of 8% to 9% pa from first class
covenants who provide a good, solid rental income stream.
There are many lenders willing to provide loans for commercial property.
They will base their offer of mortgage primarily on the tenant's ability to pay
the rent rather than just the landlord. Moreover, the better the tenant, and the
longer the tenancy term, the lower the interest rate you can negotiate. There
is no standard rate: some commercial lenders set a fixed margin over a
defined independent base rate such as LIBOR. Payments are usually
collected quarterly to match the rents, which are also normally paid quarterly.
So although you might receive a lower rent with a higher quality tenant, you
may pay a lower interest rate and management costs are lower. The gearing
advantage therefore remains intact and also, the better the tenant the lower
the risk element. In short, it makes good sense to seek out investment
property with the best possible tenants.
Syndicated purchases
Unfortunately, prime tenants normally like to inhabit expensive property. If
you like this sort of investment property, you may have to join a syndicate of
like-minded investors if your cash is insufficient to provide the deposit for a
single property investment. There are a few specialist companies who deal in
syndicated commercial property transactions, some even organising the
mortgage on behalf of the syndicate. (See www.helmsley.co.uk).
It is also possible to build your own commercial investment by developing a
commercial unit in a particularly desirable location, sometimes pre-let to a
good tenant. Again, specialist syndicates are available and you are now very
much in the professional sector.
In short, the gearing concept works very well with both residential and
commercial property. As with any investment which promises a higher-than-
average return, expect there to be a downside risk. But with common sense,
such risk can be managed so as to be at an acceptable level.
- oOo -
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How to Become a Millionaire
This section is designed to encourage those who feel confident enough with
the principles of gearing and of buy-to-let in general to make a major
investment in the commercial mortgage sector.
If you would like to have a million pounds in say 25 or 30 years time, it
essentially depends on what growth rate you can achieve from a reasonably
small starting capital.
Growth Rate to
achieve 1M
Starting capital needed
for a 30 year term
Starting capital needed
for 25 years term
10% pa 57,309 (17.4) 92,296 (10.8)
15% pa 15,103 (66.2) 30,378 (32.9)
20% pa 4,213 (237) 10,483 (95.4)
25% pa 1,238 (808) 3,778 (265)
The table above shows that it is possible with high growth rates and smallish
capital or visa versa. The longer the term, the better: the extra 5 years makes
a lot of difference. The approximate growth factor is shown in brackets
multiply any starting sum by this factor to see the end result. A million pounds
may sound a tidy sum and it has that lovely sound to it, until you look at what
inflation can do: -
Inflation rate Value of 1M
in 25 years
Value of 1M
in 30 years
2% pa 609,500 552,000
4% pa 375,100 308,300
6% pa 233,000 174,100
8% pa 146,000 99,400
Its probably safe to assume that the purchasing power of 1,000,000 might
well fall by 50% in twenty-five years time. Investing 1M for income, a 10%
annual return can then produce 100,000 gross annual income say 50,000
in real terms at todays prices. But its possible to live quite well on that
income, regardless of any other income you might have.
We have seen from the section on buy-to-let that it is possible to achieve
good returns on both residential and commercial property, provided you are
prepared to face up to the gearing risks. Let me restate the argument, but
now using a good quality commercial property as a simple example, yielding
say 9% pa. Suppose you have 50,000 cash available, or you can raise it
with a remortgage on your own home.
Now follow down the line of figures hereunder to understand how you could
gear up to achieve a return in excess of 25% pa.
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Buy investment property 200,000
With a mortgage of 150,000 (75% LTV)
Capital investment needed 50,000 (initial deposit)
Income from property @ 9% 18,000 pa
Cost of mortgage @ 8% 12,000 pa interest-only
Net Income 6,000 pa (re-invested @ 7%)
Running yield on capital 12% pa (6,000 x 100 / 50,000)
Property grows by 5% to 210,000 after one year
Profit on sale 10,000
Additional return on capital 20% pa (10,000 x 100 / 50,000)
Total return in year one 32% pa (12% + 20%)
Costs and expenses are ignored although commercial leases are usually fully
repairing and insuring, and are far less trouble than residential shortholds.
But let us say the gross yield reduced to only say 25%, and you could achieve
this every year, your million pounds would be reached in less than fourteen
years. In 25 years 50,000 could then be worth 13,000,000. It only takes
seventeen years at 20% pa return to reach a million.
Tax
There is also tax to consider. But fortunately, mortgage interest and other
management expenses can be offset against rental income for income tax
purposes. Also, no capital gains tax is payable until you sell the property. So,
if you arrange for the mortgage interest plus expenses to equal the rental
income there is no income tax to pay. You can do this by picking a lower
yielding but higher growth potential property and maximising your mortgage
by raising a re-mortgage on your own property just after you have arranged
the commercial mortgage. Although the extra mortgage is secured on a
private residence, the taxman looks at how the money was used, not where it
came from: if it was a commercial venture, it can generally be offset for tax.
Capital gains tax now enjoys taper relief. After 10 years the tax is down to
just 20%, and then only when you sell the asset and is only payable on the
gain less buying and selling expenses. But why sell? If you have picked a
good asset, you simply increase the borrowing as it rises in value and rents
are reviewed, and use such extra loans to purchase additional property.
Save the surplus
Any surplus rent, after charges, could also be saved up as deposit towards
the next purchase. The best way of doing that is to enjoy the best short term
return possible a current account mortgage or a flexible repayment
mortgage on your own home as described earlier is an excellent, safe short
term investment, and is perfect for parking rental income.
You may think that using the surplus rent to repay part of capital owed on the
commercial mortgage might be as good. But you are enjoying tax relief on
that mortgage - it is as if MIRAS applies on the full loan and at the full rate.
8% pa gross interest only actually costs 5.6% net of 30% tax, or 4.8% at 40%
tax. So the commercial loan is only worth repaying if you cannot achieve the
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same net interest rate return elsewhere. A flexible residential mortgage at
say 7% offers an investment return of 7% - net of tax.
Continuing the example, after 30% tax, the rental income surplus of 6,000
pa reduces to 4,200. Invested over five years at 7% pa produces 24,153.
Five years later
Let us continue with the example above and look at the position five years
later. If the property grows at say 5% pa it will have increased from 200,000
to 255,000, a 55,000 increase. The more valuable property is now eligible
for an increase in mortgage. The reviewed rent could now be increased to
say 22,000 pa, so the situation after five years is as follows:
New mortgage now 191,250 (75% of new value)
Mortgage costs @ 8% 15,300 pa
New rental income 22,000 pa (<9% pa)
New net income 6,700 pa
Cash from new mortgage 41,250
Cash from saved rent surplus 24,153 (after 30% income tax)
Total cash available 65,403 deposit - next property
65,000 is now a sufficient deposit to purchase another 260,000 property,
assuming another 75% mortgage, and you double your assets.
Assuming yields were roughly the same, in another five years the exercise
can be repeated again, only you can now buy two more new properties
bringing the total to four.
In ten years time
If you sold up all four properties after ten years you could have about
328,000 after repaying the loans and before capital gains: all from an initial
investment of 50,000. This represents a return of about 20% pa after 30%
income tax on the surplus rent. Capital gains tax need not apply if you simply
keep the property and re-gear to buy a further four properties.
In twenty years time
Repeating this exercise for another five years gives you eight properties in
total, and sixteen properties in another five years. Ten more years in total at
20% pa would bring up the free capital in now sixteen properties to about
2M. It has taken just twenty years in total to do it. The rental income less
the mortgage interest, if now simply taken as income, would be around
250,000 pa before income tax, assuming the 12% pa running investment
yield is sustained. Again there is no need to sell the property: one could
happily live on that income thereafter, enjoying regular rent reviews to combat
inflation. If your children inherit the portfolio on your death there is no capital
gains tax to pay. As a business asset there are also opportunities to mitigate
inheritance tax, but you need separate advice for that.
I have not included several important items for the sake of simplicity, but they
must be included in a real scenario. There is the question of stamp duty on a
purchase, which can take as much as 3.5% of the property value, and also
legal and mortgage valuation fees which can take another 2%. This could
take out the entire first years growth of the property, so one should allow for
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that in growth projections. One way is to simply knock one year off the growth
term and project at the expected growth full rate. Another way is to project at
a lower growth rate. For example, 5% pa over four years produces roughly
the same end value as 4% pa over five years.
Interest-only, fixed rate mortgage
The mortgages have each been assumed to be interest only to enhance the
yield. Lenders are usually quite happy to do this provided there is a sufficient
term left on the lease. There is no point in repaying any capital while the
gearing is making money indeed, in theory, there is never any need to repay
any loan whilst the overall growth (running income plus capital growth)
exceeds the mortgage interest.
A fixed interest loan is quite appropriate for a portfolio of this nature to at least
minimise the downside risks. Commercial rents are usually pretty stable and
so an equally stable mortgage payment produces a stable surplus.
Remember the risks
Now while all the above has been very simplified, my aim is to hint at what is
possible. An 8% mortgage rate may be a bit on the high side, but then I have
ignored buying costs. I have ignored time differences when gross income is
invested and tax is actually paid a year or more later. Obviously the property
could grow faster or slower than 5%; it could even fall leaving you with a net
loss. But these are the inevitable risks that need to be taken to achieve
rewards of this magnitude. There is safety in numbers better a larger
number of smaller properties than the other way round, unless a really solid
covenant is available from a larger property.
Spreadsheet tool
A spreadsheet is included called Property Portfolio and will enable you to
play with various scenarios. The aim is more to develop the principles of the
business model, rather than as an accurate plan. The end result is very
sensitive to the LTV selected, and the property growth rate is important too.
In real life, yields and growth rates vary from year to year: but since property
is a real asset, it is linked to the inflationary process and therefore
compensates to an extent for unpredicted inflation.
I also suggest you become familiar with the Investment Property Return
spreadsheet, which enables all the costs to be entered for a specific property
transaction in order to calculate the possible return on capital (expressed as
an IRR).
Summary
In short, a carefully selected, geared portfolio of good quality commercial
property, such as warehouses could produce a sizable profit over the medium
to long term, and provide a good source of income thereafter. 1M is fairly
easily possible before you retire provided you get cracking in your early 40s
at the latest.
I have used an example of 50,000 to achieve 2M in twenty years. In theory
you could scale down with a lower starting capital, but good commercial
property requires a sizable commitment and even a 200,000 property is
somewhat light. One way to build up to this deposit is your own home and a
remortgage at the right time. A house costing just 100,000 today would
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grow to about 160,000 in ten years at 5% per annum. Thats a 60,000
increase for a start.
Finding and selecting the commercial properties themselves is clearly crucial.
You will need to bone up on the intricacies of commercial property and
perhaps take on a professional commercial mortgage broker and a buying
agent to guide you. It is worth explaining your amateur status to start with
since on the whole, people in the professional sector are very helpful to
beginners who may become substantial clients in the future.
Buying property is probably less risky than attempting to make money out of
the stock market, although it is less easy to take out cash quickly. Investing in
property does entail a long-term commitment: add in some careful
management and the results can be quite startling. My own modest portfolio
is, so far, performing as it should but one must never be too complacent.
There is the ever-present risk of a vanishing tenant, of interest rates soaring
beyond the rental income and the maintenance of the property being higher
than planned. Caveat emptor buyers beware.
- oOo -
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Manleys Maxim: Logic is a systematic method of arriving at the wrong conclusion with
confidence
From the Lenders Perspective
A lender is in business to make money; even a mutual building society must
operate so that it at least does not lose money. All lenders borrow from either
the retail market (e.g. people making deposits) or the wholesale markets (e.g.
Institutions buying portfolios). Some lenders use both sources. The retail
market is less sensitive to interest rates but is expensive to manage, whereas
the wholesale market is relatively efficient to those who understand it.
Wholesale lenders are themselves highly geared. By carefully enhancing the
credit rating of their wholesale products, they can make do with capital as little
as 2% in some cases that is rather like borrowing on an LTV of 98%.
Securitisation
Securitisation is an increasingly common way of raising cost effective finance
for a wide range of different assets that were previously difficult to finance. It
was originally developed in the USA and the idea came to the UK market in
the 1980s. The process, the parties involved and the documentation, as well
as pricing, can appear mysterious to the uninitiated.
The securitisation process is effectively the bundling together of a group of
individual mortgages such that they may be treated, for funding purposes, as
a single entity and made available to prospective investors in mortgage debt.
Mortgage debt is seen as a relatively attractive and safe investment by many
institutions, such as pension funds. Securitisation allows lenders to raise
money in the money markets, then lend it on to residential property
purchasers and finally sell the resulting tranche of mortgages on to other
institutions in bulk. This is also known as "off balance sheet lending" since
the debt does not form part of the lenders assets. This process does not
affect the terms and conditions of the individual borrowers in any way, and
most people are quite unaware that their mortgage cash may have actually
started off in someone elses pension fund.
Sales Channels
Most lenders sell through two main channels: direct, via branches, telephone
sales or web sites, and indirect through mortgage intermediary introducers
such as brokers and estate agents. These days it is common to pay
intermediaries a commission for completed business, since brokers can no
longer rely on commission from endowment policy sales as an income
source. They are expected to market and sell the lenders products and
rightly expect a commercial reward for doing it successfully.
The Internet shows great promise for the financial services business in
general, not just as a sales channel, but as a highly efficient process that can
be easily automated and integrated with a lenders back-office systems.
The Internet is a worry to some intermediaries, as they fear many prospects
who would otherwise use them, can now more easily go direct to lenders on
the web. But the truly independent brokers such as John Charcol can
themselves operate successfully on the web and add value to their services,
since the choice to most people is still bewildering apart for my readers thus
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far, naturally. An on-line broker can more easily locate the optimum product
to suit their clients and this area will certainly grow.
Interest Margin
Whichever way lenders obtain funds, they all need to lend at a higher interest
rate than they borrow called the margin to cover their marketing and
administration expenses for both borrowers and their own investors, and still
leave a profit.
Lenders have to include the costs of processing new applications, valuing the
property and investigating the credit worthiness of the applicant. Some of
these costs are recovered directly from the borrower through valuation or
administration fees, which can themselves be added to their loan. Once the
case completes, on-going administration is required to collect the monthly
payments and manage such activities as producing statements, dealing with
rate changes, redemptions and arrears and so on. There must also be a
reserve for possible losses and the administrative costs of funding the
operation.
Some lenders also obtain additional income from other sales activities,
typically commissions earned on household insurance policies, payment
protection insurance and indemnity guarantee insurance. All the net costs
and supplementary income streams must be considered in order to decide
just what the overall margin must be. Individual mortgage products can then
be designed and marketed in the best way to suit the brand of the lender,
their sales channels and their speciality.
Designing the products
Most lenders would consider a model rather like the loan comparator
spreadsheet to ensure that their offerings achieved the right return. The initial
expenses to a lender will differ to that of the borrower so the lending IRR will
not be the same as the borrowers IRR. For example, the borrower may pay
for the house valuation and the legal fees, which will increase their IRR,
whereas the lender does not pay for these fees. On other hand, the lender
has to pay a processing cost, which is not directly paid by the borrower.
The mortgage market is very competitive. There is an oversupply of funds at
the moment, which has trimmed margins on standard mortgage products right
to the bone. Consequently, lenders devise all sorts of methods to attract
business, even launching loss-making products in the hope that the margins
can be relaxed in the future when no one is looking. The spreadsheet entitled
Mortgage Product Design is for lenders and other professionals to use to
help ensure their designs make the appropriate margin. Borrowers might also
like to have a peek, as it will help them better understand the lenders
position.
- oOo -
106
Popes Rule: Blessed is he who expects nothing, for he shall never be disappointed
Equity Release and Home Income Plans
Once you have retired, and the mortgage is paid off, you may reflect on the
fact that you are house rich but cash poor. You own a nice house but your
pension is just not sufficient to bathe you in the luxury you know you deserve.
What you might need is some sort of Home Income Plan a scheme that
enables you to still live in your house, but you give up a part of its equity on
death in return for an immediate cash sum, or income. They are also called
equity release plans.
As a safeguard to protect investors, the main specialist home income plan
providers devised a collective initiative called Safe Home Income Plans
(SHIP). Participating companies must observe a code of practice, which
obliges them to provide fair, simple and complete presentation of their
schemes. As a further safeguard, a solicitor must check your plan before you
sign up.
There are two main types: -
Mortgage
You take out an interest-only mortgage and buy an annuity with the
proceeds. An annuity produces a lifetime income in exchange for
capital. The income is equal to the difference between the annuity
income that you receive and the mortgage interest that you pay out
each month.
On death, the annuity ceases and the house is sold to repay the
original loan. Your estate gets the rest and is distributed in accordance
with your will.
Couples can take out a joint life scheme so the income continues until
the last death.
The income is not very high and you have to be well into your 70s to
make it even moderately worthwhile.
Reversion
You sell your house (or a portion of it) for cash to an institution,
typically an insurance company, for a discounted figure. But the
purchaser allows you to live there rent-free until the last partner dies.
The price offered is quite a bit lower than the current value of your
property. The funder has to take account of no rental income for an
indeterminate period, and also reserve for the possibility that the
property might not be looked after as well as before once the aging
occupants freehold interest has disappeared.
Nevertheless you can get quite a reasonable sum from this
arrangement, and then convert it into income using a suitable
investment, but all or most of your equity is gone. If the house
subsequently falls in value, you are unaffected.
The amount of cash (which is tax free) payable depends on todays
value of the house and the applicants ages. The older you are, the
greater the proportion of cash payable. The younger you are, the
longer you will have to enjoy the proceeds.
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The cash can be used for any purpose. You can invest it for income or,
for certain schemes, receive the cash in stages over a period of years
like a tax-free income.
There is little risk to the homeowner in either scheme provided they are
properly advised and deal with a SHIP provider. You can also move house
with these schemes.
The only ones possibly disadvantaged with either of these schemes are the
intended beneficiaries, who clearly receive less than otherwise as some of the
estate is being used to supplement their parents income. Fortunately, most
children take the view that they would rather see their parents comfortable
than hope for a larger legacy. Many children are better off than their parents
these days with more sophisticated pension arrangements and state benefits.
Annuities
If you need a regular income for the rest of your life you could purchase an
annuity. In exchange for capital an insurance company will guarantee a
monthly income for life. An annuity is exactly like a capital repayment
mortgage where you are the lender and the institution pays you the monthly
repayment. The term of the mortgage is to the date of death. This is in
practice your life expectancy. Take the following example.
An insurance company will first estimate your life expectancy (or joint life
expectancy for couples). For the sake of a simple example, assume this is
only ten years. If you had 20,000 to invest, the company would be able to
return one tenth of your capital back to you each year. Thats 2,000 per
annum.
In addition, interest of say 600 pa on average is also payable. So your total
income would be 2,600 per annum (13% pa), of which 2,000 is called the
capital element (and is tax free) and 600 is the income element and subject
to tax. The actual figures depend on your particular age and life expectancy,
and the income is usually paid monthly in advance.
If you should live longer than the ten years in this example, the insurance
company will still continue to pay you the 2,600 per annum until your death.
On the other hand if you died earlier the annuity ceases. Since an insurance
company deals with a large number of people it can offset the loss it suffers
from a longer-than-average life with the profit obtained from shorter lives. But
if you and your partner died earlier than expected, neither of you are in a
position to worry about it!
Income tax
You will have probably already spotted in this example the comparison with a
capital repayment mortgage. A 20,000 mortgage over ten years at 6%
interest would also cost about 2,600 per annum, payable monthly, the same
as used in the example above. But with such a mortgage the mix of capital
and interest varies each month with more interest to start with.
Fortunately the revenue only taxes the income element of a purchased
annuity the capital element is tax-free since it is a return of your own
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money. But they take a simple approach and assume that the interest and
capital element is constant throughout. The capital element is roughly equal
to the initial investment divided by the life expectancy. This is good news,
since the levelled interest element is less than it should be to start with so the
income tax is lower than is should be to start with but higher later on.
This taxation treatment differs from Pension annuities (called compulsory
purchased annuities) where the whole annuity income is taxed, but then the
initial investment was tax deductible at the time. This is why it is usually worth
while taking the maximum tax free lump sum from a pension, even if it is
invested right back into a purchased annuity, because the tax treatment for
purchased annuities is more favourable than for compulsory purchased
annuities.
What age should you buy?
The older you are, the higher the income you receive from an annuity, but the
less time you have to spend it. Younger annuitants do not necessarily get
poorer value for money, just a lower annual amount for a longer period,
although a fixed, lifetime income may be eroded by inflation.
Varieties of annuity
There are various types of annuities. For example: -
Guaranteed. In exchange for a lower income, you can guarantee a
minimum payment period regardless of death during that period
typically 5 or 10 years. They will of course continue to pay income until
death regardless of your actual life span.
Capital Protected. In exchange for a lower income, on death the
insurance company will return your initial capital less any gross
payments already made.
Joint. Joint life annuities provide an income until the last survivor dies.
Obviously the income will be lower as joint life expectancy is longer
than for a single life. But there are various combinations. For example,
a pre-agreed reduction in income on the first death will increase the
initial income.
Increasing. You can choose an income that increases by a preset
amount each year or even by inflation. The initial income is lower to
start with.
Equity-Linked. Instead of a guaranteed income, you can opt for your
annuity to be linked to the performance of an equity or property fund
such as an insurance companys with-profit fund.
Mathematically, all varieties of annuities are near enough identical value for
money. They operate much like a repayment mortgage over a pre-set
lifespan. The IRR is much the same for almost any combination when you
take life expectancy into account. Bearing in mind the insurance company
take the risk of you living longer, the deal can be a good one.
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Some people just do not like the idea of losing their capital". This is an
inaccurate view, since the capital is not actually lost it is paid back over a
period. As I mentioned earlier, if you died earlier than expected, before the
capital element was all paid back, you couldnt have taken it with you anyway.
Better for you to have the guarantee of a lifetime income regardless of how
long you live in exchange.
Many people feel than annuities currently offer a bad deal. But this is due to
two things: interest rates have fallen and life expectancy has increased. This
does not affect the basic principle of an annuity which is a safe income
augmented by withdrawing capital, but without risk of actually running out of
capital. Imagine any alternative investment that produces such a high, safe
income. The equity-linked variety would suit a more adventurous investor, at
least in part.
Shared appreciation mortgages - SAMs
Recently there has been another type of home reversion scheme on the
market called a SAM which stands for Shared Appreciation Mortgage.
The Bank of Scotland first started the scheme in late 1996 and since then one
or two other banks occasionally provide funds. The main feature of a SAM is
its simplicity.
Typically the bank will advance you 25% of the value of your property, interest
free in exchange for 75% of the appreciation of the property when you either
sell or die. Thats basically it.
Suppose your house is worth 100,000. Borrow 25,000 and pay nothing
more until you sell or die. Suppose you sell after 10 years and the house is
then worth 160,000 (4.81% pa growth). It has appreciated 60,000. You
therefore then own the bank the 25,000 you borrowed originally, plus the
shared appreciation interest of 75% of 60,000, which totals 70,000.
So you borrowed 25,000 and repaid 70,000 10 years later. That is an IRR
of around 10.8% per annum over double the house growth rate. This is an
expensive loan, but the risks are taken entirely by the lender, who is
effectively investing in a rent-free property. If the house went up by more, the
amount you owe increases too. There are a few other permutations, but at
the time of writing, no other lender has funds, so we await a new lender to
enter the fray when they do, the cash tends to be snapped up pretty fast.
Reverse mortgages
This is an idea that I devised myself in the early 1990s but later abandoned.
There were two reasons for this: house prices were falling and home income
plans generally were reeling from a scandal involving a well-known Building
Society. The lender was advancing elderly homeowners roll-up loans loans
with no interest to pay month by month, but the interest was added to the
capital debt. The cash raised was then invested into investment bonds from
which income was withdrawn. In some cases, borrowers used bond
withdrawals to repay the interest on the loan instead of rolling it up.
110
In short, the bonds fell in value because of the heavy withdrawal rate, the
house fell in value because the market was poor, and the loan outstanding
rolled-up until it exceeded the value of the property. Elderly pensioners were
on the verge of losing their home, their capital and their income over a short
period of years.
This debacle highlighted the problems in dealing with elderly people wanting
to convert their house into income, but who were unaware of the pitfalls. All
home income plans were suddenly suspect, including my own fledgling
scheme, despite the guarantees built in. It worked like this.
Instead of advancing a capital sum and expecting the borrower to invest it
somewhere else to obtain income, why not advance the income itself as a
month-by-month loan. Since then the lender was effectively paying the
customer a monthly income it was like a mortgage in reverse.
Example
As an example, imagine a 65 year old couple living in a 100,000 house. It is
possible to pay them 211.35 per month tax-free, guaranteed for the rest of
their lives, possibly another twenty years, with access to equity. How does it
operate?
The monthly income is actually a monthly loan thats why its tax-free. The
lender charges interest on it and 7.5% pa is assumed in this example.
Month by month the loan gradually increases. Since the advances consist of
small amounts of income spread over a period, rather than large chunks of
capital, the interest roll-up is small to start with. The house appreciates in
value also; 4.25% pa is assumed in the table. Few people live to age 100. In
fact the actuary I spoke to some ten years ago said they assumed no one
lives beyond 100 for all practical purposes. That could of course change.
The monthly income figure of 211.35 is worked out so that the loan equals
the expected property value at the youngest borrowers 100
th
birthday. This is
actually 429,202 in this example - a sizable figure but few are expected to
reach it.
Flexible payment facility
The whole 35 year period is illustrated on the next page. In practice, several
other important ingredients were offered with the original product. Firstly,
every three years the borrowers had the opportunity to ask for a revaluation of
their property. If it was higher than that expected, and interest rates had not
increased, the borrowers could increase their income. Moreover, borrowers
could repay a portion of their loan and withdraw it later rather like the
flexible mortgage discussed earlier.
111
Reverse Mortgage Payment and Equity Table. The life expectancy is
normally about aged 85 - there is still plenty of equity left and LTV=51%
Year Age Monthly Total loan House Equity
End Income year end Value on sale
1 66 211.35 2,625 104,250 101,625
2 67 211.35 5,454 108,681 103,226
3 68 211.35 8,503 113,300 104,797
4 69 211.35 11,788 118,115 106,327
5 70 211.35 15,329 123,135 107,806
6 71 211.35 19,144 128,368 109,224
7 72 211.35 23,255 133,824 110,568
8 73 211.35 27,686 139,511 111,825
9 74 211.35 32,460 145,440 112,980
10 75 211.35 37,606 151,621 114,016
11 76 211.35 43,150 158,065 114,915
12 77 211.35 49,125 164,783 115,658
13 78 211.35 55,564 171,786 116,222
14 79 211.35 62,503 179,087 116,584
15 80 211.35 69,981 186,699 116,718
16 81 211.35 78,039 194,633 116,594
17 82 211.35 86,723 202,905 116,183
18 83 211.35 96,080 211,529 115,449
19 84 211.35 106,164 220,519 114,354
20 85 211.35 117,031 229,891 112,859
21 86 211.35 128,742 239,661 110,919
22 87 211.35 141,362 249,847 108,485
23 88 211.35 154,961 260,465 105,504
24 89 211.35 169,616 271,535 101,918
25 90 211.35 185,409 283,075 97,666
26 91 211.35 202,428 295,106 92,677
27 92 211.35 220,769 307,648 86,879
28 93 211.35 240,533 320,723 80,190
29 94 211.35 261,831 334,353 72,522
30 95 211.35 284,783 348,564 63,780
31 96 211.35 309,517 363,377 53,861
32 97 211.35 336,171 378,821 42,650
33 98 211.35 364,894 394,921 30,027
34 99 211.35 395,847 411,705 15,858
35 100 211.35 429,202 429,202 0
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Guarantees built in
The first years income level was guaranteed for life. Furthermore, an
insurance policy was put in place to guarantee to the lender that his debt
would always be repaid, even if there were negative equity, without recourse
to the borrowers. But if the income was increased at a subsequent
revaluation, it could fall back to the initial guaranteed level if property values
or interest rates were adverse at the following review date but never lower
than the initial, guaranteed level.
Reverse Mortgage Equity
90,000
95,000
100,000
105,000
110,000
115,000
120,000
66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85
Age
A
m
o
u
n
t
The borrowers view
From the borrowers perception, a reverse mortgage is superior to a reversion
scheme, since there is equity available to the estate or if the borrower wishes
to move at any time and it is as easy to calculate as any other mortgage: a
full reversion takes all the equity. A reversion is not so easily reversible.
No investment is required. Indeed their own home is the investment, and any
increases over the base figures enable them to enjoy a higher income. The
income would be about the same as a reversion scheme and a lot more than
the mortgage plus annuity method.
The equity left to the estate on death will be probably a lot more than other
reversion schemes, depending on how long the borrowers lived. It peaks at
about the time when death is expected, as can be seen from the graph
above, so the beneficiaries should be happy. The borrower could still sell up
and move into a nursing home and have some cash to pay for it. Even if they
did make aged 100, there might well still be surplus equity in the event.
The actual product also differed in that there were some initial fees added to
the loan, part of which paid for the mortgage indemnity guarantee and part
went as a commission to an introducer. Also the cost of a periodic valuation
during the life of the scheme could be added to the loan as well.
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The Lenders View
From the lenders perception, the scheme offered the prospect of a long-term
loan with no collections required and little administration. The main drawback
is that the cashflow would be erratic indeed zero in the early years until
someone dies: although the underlying return on capital was still there, it was
effectively being reinvested. It would also take some time to build up a
decent sized loan book, as the initial lending figures are so small.
This scheme could be re-launched: the indemnity insurance policy must be
renegotiated, a brochure prepared, a simple administration system installed
and the scheme could be up and running in no time. No doubt the insurers
and the lenders will want to prepare their own initial income tables based on
their view of the future. There are only three variables: -
1. Life expectancy
2. Long-term interest rates
3. Long-term property growth rates.
The inevitable spreadsheet entitled Reverse Mortgage illustrates the
relatively simple mathematics behind the scheme.
But now I have retired, I must leave the possible re-launch of the Reverse
Mortgage scheme to someone else perhaps to you dear reader. There are
a massive number of prospective customers over the age of 60 with good
sized properties, and are longing for a decent, simple scheme which provides
genuine value for money for both customer and provider.
- oOo -
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Its better to travel hopefully than to arrive
Epilogue
What has been achieved at the end of this sometimes-complex journey? My
objective was to pass on some of the key general principles relating to loans
and mortgages, and of use generally for other financial analysis.
I hoped to convey sufficiently general-purpose concepts so that readers will
be equipped to perform their own analysis on the many products available
throughout the financial services industry, whether loans or not. Compound
interest and the IRR apply just as much to an investment as it does to a loan.
I have also exposed some of the pitfalls in the lending industry flat rate
loans, Rule of 78, annual compounding but monthly collections, and interest-
only loans with the wrong sort of investment plan. We identified the irony that
the safest investment is unsuitable to repay an interest-only loan.
We looked at the flexible mortgage and, in particular, the current account
mortgage. This method of lending is very likely to become commonplace in
the near future. There is no reason why a single, cheap flexible mortgage
cannot replace all other sorts of lending, such as credit cards loans, car loans,
hire purchase, unsecured loans and second mortgages. At the same time, it
can be a home for all your short-term investments too, but at rates
significantly higher than any other deposit-taker would pay.
I have suggested that while personal attitudes to risk and financial skill-level
will affect ones ultimate choice of a loan scheme, the use of an accurate
comparison tool is vital in order to put subjective judgement into context and
to enable scheme-evaluation to be consistent. The IRR and the NPV provide
this tool.
We also examined ways of profiting from gearing, in particular, how to
become a millionaire from building up a portfolio of investment property. I
also hope that the downside risks were made prominent enough, as nothing
in this life is ever certain.
If you make it to retirement, you may want to turn your house back into
income, and the methods for doing this were discussed. A challenge was laid
down to a lender wishing to take up the Reverse Mortgage concept, which
provides the best of all worlds for both lender and borrower.
I sincerely hope you will find the spreadsheets of use. They have been quite
carefully designed so that they are as general purpose as possible. As in any
software, there might well be a bug or two, so please e-mail me if you
discover one mkelly@foxwood.me.uk.
The Internet and the digital revolution
E-commerce is now beckoning the consumer with promises of transparency
and choice. It is now possible for anyone to enter some basic personal
details on to a web page, and then an electronic robot will trawl through
hundreds of schemes in just seconds, returning with an ordered best-buy list.
This process in theory heralds a perfect marketplace, with suppliers products
competing where they should, in personal appeal rather than mass appeal.
Such mass customisation is effortless with a computer. The future of the
direct sales force, representing just one company, is under threat: prospects
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can now go-direct so much more easily, and compare competitors products
on the web or use an on-line site that does the comparing for you.
The Digital broker
Independent Financial Intermediaries (IFAs) who embrace the Internet are on
a winning ticket. There is still a need for someone to sift through a large, ever
changing list of available suppliers and schemes and then attempt to match
them to an array of different consumer-types. This process is itself able to be
digitised and some of the variables were discussed in this book.
But, at the time of writing, I have yet to see a truly accurate web site, which is
able to identify the individual type of consumer, source every possible lender,
and then list the results in a genuine value-for-money order, using the IRR as
the measure over a realistic life span. There is no doubt that this will happen
soon.
Transparency and commoditisation
Lenders and suppliers generally are right to be concerned about this process.
Borrowers are now demanding more transparency: hidden costs must be
exposed and products must be made simpler so that lenders can no longer
camouflage bad-value with obscure small print. The larger banking lenders
have probably more to fear than the specialist lender and the mutual
societies. Specialist lenders can command their smaller but specific niche
areas, and can retain their competitive position because of their smaller
mass. The Halifax or Abbey National are forced to serve the standard,
commodity market in large volumes to survive, since the proportionate effect
of niche products is so small in comparison to their size. For their commodity
products to remain attractive, even a small interest rate reduction can make a
massive difference to shareholders profits.
Integration, digital efficiency and flexibility
The web is a perfect sales channel for almost any cerebral product requiring
no physical stock, and financial services fit very well. But the front end
processes must be integrated with the back end administration for complete
success: the sales process must be seamlessly connected to the
underwriting and case processing area and thereafter to the collection and
administration departments in order to achieve the overall speed and
efficiency improvements everyone expects. Such efficiency brings cost
savings for the benefit of everyone. Eventually, it might be possible for
potential borrowers to auction themselves on the web, with lenders bidding
for their mortgage. The lenders interest rate margin will change depending
on the attributes and quality of the case being offered to them.
Borrowers expect to be able to apply for a mortgage or a loan on-line. Most
people hate form filling and a mortgage application form is one of the worst.
Successful lenders will facilitate this process, and also give customers an
opportunity to track the progress of their application on the web without
having to hang on to the telephone listening to a recorded voice saying how
important your call is and that you are twenty seventh in a queue.
Once the mortgage has completed, digitisation still has a role to play. For
example, a flexible mortgage can be operated by the borrower through the
lenders web site. An unlimited set of repayment schedules can be set, reset
or cancelled at the click of a mouse. Statements would be immediately
116
available on-line. Since the process can be entirely automated, no human
need be directly involved and so the costs of managing your own mortgage
are down to just your own time, probably on one wet Sunday afternoon.
So, soon you will be able to apply for, complete, service and redeem your
mortgage entirely electronically. This will save costs and will enhance
efficiency, speed, and flexibility for both supplier and consumer. The supplier
will profit from savings achieved: market forces will ensure that much of the
saving will have to be passed on to the consumer.
Technophobia
Some people fear this revolution. They are concerned that they are not able
to cope with computers it all seems so fast and clever. I suspect that there
will be a market for these consumers, who want to be served in the traditional
manner. Traditional products will still be available but with more expensive,
old-fashioned paper transactions, telephone and face-to-face people
transactions, the costs of such an old-regime product will make them more
expensive.
The future is bright
Much of all this is happening right now. There are still many aspects needing
improvement. The web is still slow the World Wide Wait is still a worthy
acronym. But new, much faster connections are just on the horizon.
Moreover, mobile digital communication will soon connect to the web at much
faster speeds than current WAP phones can achieve.
Future technology will change the world as we knew it far more
comprehensively than we have ever experienced before. The original
industrial revolution took over a hundred years to take full effect: we can now
witness an industrial revolution almost every five years - and reducing!
In such a fast moving era, it is vital to hold on to the basic principles in order
to cope with these on-going revolutions and I hope the principles shared with
you herein will remain intact for many years to come. I wish my grandchildren
well in their new world I actually really rather envy them
- oOo -
117
118
Annex A
Low Start Flexible Payment Mortgages and Index Linking
Most people enjoy a higher standard of living when they are older. The first
few years of adulthood are invariably tight, particularly for a young couple
bringing up children and starting out on the lower rungs of a career. Once the
children are older, mother may well have returned to work, and father has
been promoted or used his experience to obtain a better job. Money
becomes easier later on in life.
The monthly mortgage payment seems so much more of a burden at the
start. It always seemed to be such a high proportion of take-home pay. In
fact, most people struggle to finance their first house, which is the best they
can afford at the time and so the initial years of a mortgage are always the
toughest.
Even if ones standard of living remains unchanged, inflation will ensure that
the mortgage payments become easier with time. Inflation shrinks debt.
Apart from the inevitable variation in interest rates, conventional monthly
payments always follow a level course. A normal repayment mortgage is
often called a level repayment mortgage as the payments are designed to be,
well, level.
It's when you are young and full of energy that surplus spendable cash would
be of most benefit, yet life now conspires to deliver the heaviest expenditure
compared with your modest income. When you could be exploring the world
and having fun, parties, cars, holidays and all the exciting stuff of life, there is
furniture to buy, children to clothe, the mortgage to pay as well as the HP on
the car, the TV, the computer, even school fees. So much to do - so little
money: we've all either been there or are there right now!
Later on in life the children are independent (sometimes), the HP is paid off
and the mortgage burden seems to be less significant now with a good, stable
income coming in and the wife back at work. Ones standard of living is
starting to be really quite bearable.
Why pay more at the beginning when you can pay more at the end?
The biggest monthly burden for most families is usually the mortgage
payment. In 1979, when inflation was still in double digits, it seemed to me
that monthly mortgage payments really shouldnt be level at all. It would be
much easier for borrowers if they started out with lower-than-average
mortgage payments, even though they may have to increase subsequently.
Later on, most people can more easily afford mortgage payments; it is at the
start when they need to be cheaper.
Low start payments, as they were soon called, gave borrowers the choice of
either a better standard of living when they were young and most needed it, or
they could buy a more expensive house for the same initial outlay. Most
borrowers went for a bit of both.
The index-linked mortgage
As explained in the introduction, our Index Linked Mortgage & Investment
Company Limited was the first lender to offer the index-linked mortgage for
house purchase. It was a very simple idea. The initial monthly repayment
was about 30% lower than that for a conventional "level" repayment
119
mortgage. But this monthly repayment was increased every year by the rate
of inflation. In fact there was a guarantee that the payment would never
increase by more than the rate of inflation.
We achieved this clever bit of mathematical juggling by linking the interest
rate to the inflation rate. Inflation is measured by the Retail Prices Index,
which regularly compares the cost of a typical basket of goods as purchased
by the so-called average person. The actual interest rate charged in 1979
was 5.5% plus the RPI rate. The 5.5% was fixed. So it was as if we were
charging a fixed "real" rate of just 5.5% - "real" means adjusted for inflation.
At that time, when normal mortgage interest rates were around 15%, a mere
5.5% interest rate produced a significantly lower starting payment which
borrowers found particularly appealing.
Low starting costs that stay low in real terms
The initial monthly repayment was calculated as if the interest rate was only
5.5% pa and, although the monthly payments were increased annually by the
inflation rate, in "real" terms these monthly repayments were fixed. In other
words, the monthly cost of the mortgage, compared with the cost of
everything else, remained in the same proportion - indeed was guaranteed so
to be. If a borrower's income increased in real terms, that is to say his pay
increased by more than inflation, the mortgage repayments would become a
lessening burden. As most people expect their standard of living to improve,
compared to inflation, the mortgage payment was thus wrapped up nicely as
if it was always a fixed multiple of the average food bill.
One of our early borrowers called his index linked mortgage the "baked
beans" mortgage, because I used to liken the monthly repayments as being
the equivalent of so many tins of baked beans, the number of baked bean tins
required being constant throughout the life of the mortgage. This was an
attempt to explain what "real" meant. My wife said, trust me to use a food
analogy.
Index Linked Mortgage
0
40,000
80,000
120,000
1 3 5 7 9 11 13 15 17 19 21 23 25
Year
A
m
o
u
n
t
note debt rising then falling
Real debt always falls
House value-increasing equity
120
Borrowers could always increase their payments by more than inflation if they
chose. This meant the loan would either be repaid more quickly or the future
payments would be lower. However, most borrowers opted for the minimum
payment throughout.
The Inflation Bond for Investors
Borrowers liked the mortgage concept (I had an index-linked mortgage
myself) and we soon needed a lot more money to lend out to our growing
numbers of mortgage applicants. We used the interest link to inflation as a
method of raising matched funds from investors to support the mortgage. We
offered an "Inflation Bond" which gave a return to investors of more than
inflation, even after tax. Remember we are talking about 1979 when there
were no index-linked gilts as there are today. Inflation was not totally under
control then, and any investment that promised to beat inflation seemed
almost too good to be true. We managed to balance our books with investors
and borrowers in those early days, often with several investors per mortgage,
but it became increasingly clear that we needed a more substantial backer to
take the concept forward.
Index Linked Pension Funds
Skandia Life, then a brand new company, was under the very creative
leadership of actuary Paul Bradshaw. He recognised the demand for index
linked products and in 1980 Skandia launched the first ever index linked
pension fund. The entire fund was supported by our index linked mortgages
and we focused on marketing and managing the mortgage side and left
Skandia to supply the funding. But we still could not satisfy the ever-growing
demand for this type of mortgage.
Lazards Brothers, the merchant bankers, later in 1981 joined forces with us to
launch LILMUT. Yes, it sounds a silly name, but it stood for the Lazard Index
Linked Mortgage Unit Trust and it was specifically designed for pension fund
investments. Lazards persuaded some of their more creative pension fund
managers to give some experimental support to this new-fangled index linking
idea.
Index Linked Government Stock
By this time, the Nationwide Building Society had also launched their version
of an index-linked mortgage and at one stage we had even considered a joint
venture. The mortgage was beginning to be more understood although it was
still considered a bit niche. Nevertheless, we were still experiencing an
enormous demand for the mortgage product - far greater than the funds we
could raise to finance the loans.
The City was still sceptical about the indexing concept. Pension funds were
not particularly keen to become mortgage lenders for fear of the "ordinary
man" being too involved in their fund management processes. They hated the
prospect of perhaps having to repossess the house of a defaulting pension
fund member, probably with good reason. Eventually, prompted by the
Institutions, the government launched the first index-linked gilt in 1982. This
was a Government Stock whose value was directly linked to the RPI, just like
our Inflation Bond. This launch finally satisfied those institutional investors
who clearly wanted index linking at that time but who were nervous about
doing it with mortgages.
121
Conventionally funded low start mortgages
Having now lost out to the government who had pitched for our own funding
sources, what could we now do to satisfy the ever-increasing demand from
borrowers for a low start mortgage when we could not arrange enough
matching funds? Well, that is when we changed our name to Mortgage
Systems Limited and launched an index linked look-alike mortgage, funded
by more conventional banking sources.
We had proved the concept of low start mortgages. We knew that borrowers
also understood that future monthly repayments must increase to
compensate for the low start. So it was a relatively straightforward step to
redesign the mortgage to achieve the same cashflow effect, but with interest
linked to bank rates rather than inflation rates. There was a tenuous link
between the two anyway.
Our first low start mortgage in 1983 was funded by a bank (Scandinavian
Bank) and assumed the monthly payments increased by 5% per annum
rather than the inflation rate. The figures looked something like the graph
shown earlier for the index-linked mortgage. Both original methods are
summarised in spreadsheets entitled Index Linked Mortgage and Flexible
Payment Mortgage.
There were then many different variations, including loans that required the
payment increases to be truncated over say 5 years and to be level
thereafter. There were repayment and endowment variations. In every case,
borrowers were permitted to pay more than the minimum at any time. This
either shortened the mortgage term or reduced the minimum payment
required in future years.
Todays flexible payment mortgages are modelled much on the same lines
apart from the automatic increasing payment, so you have to elect your own
payment increase. In 1983, I used to think that someday all mortgages would
be built this way. Twenty years later this prediction might turn out to be true.
- oOo -
122
Annex B
Current Mortgage regulation, the Mortgage Code and CAT standards
At present, the regulation of mortgages is fragmented and steps are in hand
to consolidate it. Whilst the Financial Services Authority (FSA) regulates the
institutions concerned with investment, as I write, mortgages are still largely
regulated by a voluntary code, but this will change.
Regulations under the Consumer Credit Act apply to the advertising of
all mortgages, and the full provisions of the Act apply to secured
lending on loans of 25,000 or less (unless it is for the purpose of
house purchase and other limited exceptions). Firms and individuals
involved in arranging loans are required under the Act to hold
Consumer Credit Licences, which are administered by the Office of
Fair Trading.
The voluntary Mortgage Code applies to all mortgage loans to private
residential owner-occupiers unless they are already covered by the full
provisions of the Consumer Credit Act (ie they are for less than
25,000 and not exempt from the Act). Lenders subscribing to the
Code were registered and monitored by the Independent Review Body
for the Banking and Mortgage Codes. Intermediaries were registered
and monitored by the Mortgage Code Register of Intermediaries. From
November 1999, arrangements for lenders and intermediaries were
merged, and both are now registered and monitored by a single
integrated organisation, the Mortgage Code Compliance Board.
"Non-status" lending is subject to the quasi-regulatory Guidelines on
non-status lending published by the Office of Fair Trading.
The Unfair Terms in Consumer Contracts Regulations 1994 provide
remedies for potential unfairness in consumer contracts, on mortgages
just as on all other consumer goods and services.
The government has stated its intention to bring mortgage lenders into the
regulatory framework of the Financial Services Authority (FSA) with a new set
of regulations for advertising. The aim, according to the Treasury Secretary,
is to give consumers clear, comprehensive and comparable information in
order to drive up standards, cut costs, improve competition and to improve
consumers ability to make informed choices.
In the meantime, the Mortgage Code is in place and its main features from
the borrowers standpoint are summarised below.
The Mortgage Code
From 30 April 1999, every prospective mortgage customer will be given a
copy of the You and your mortgage leaflet at the earliest contact they have
with the lender (or intermediary). The shorter leaflet has been
recently redrafted and is reproduced as follows: -
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YOU AND YOUR MORTGAGE
The mortgage code provides protection for you as a mortgage borrower. It
sets out minimum standards which mortgage lenders and intermediaries have
to meet. This leaflet is designed to introduce the mortgage code to you.
The mortgage code
By giving you this leaflet, your lender or intermediary is confirming to you that
they keep to the principles of the mortgage code. This provides important
protection for you, as the code sets out:
how your mortgage should be arranged;
what information you should receive before you commit yourself; and
how your mortgage should be dealt with once it is in place.
If a lender or intermediary fails to meet the standards of the code, and you
suffer as a result, you have the right to compensation under a compulsory
independent complaints scheme.
The rest of this leaflet concentrates on the details, which are most relevant to
you when you are arranging a mortgage. We then give you an outline of the
code's main commitments. You can use this leaflet as a checklist to help you
through the process of arranging a mortgage.
Choosing a mortgage
There are three different levels of service which your lender or intermediary
may provide to help you choose a suitable mortgage. The lender or
intermediary will tell you, at the beginning, which of these levels of service
they can provide. The levels are:
advice and a recommendation on which of the mortgages they can
provide is most suitable for you;
information on the different types of mortgage product on offer so
that you can make an informed choice of which to take; or
information on a single mortgage product only, if only one
mortgage is available or if you have already made up your mind.
Check that you understand which level of service you are being offered, and
what this means for you.
Whichever level of service they provide, your lender or intermediary should
give you information on all the following areas of the mortgage you are
considering -
The repayment method (for example, endowment, capital and interest)
and the repayment period.
The financial consequences of repaying the mortgage early.
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The type of interest rate - variable, fixed, discounted, capped and so
on.
What your future repayments after any fixed or discounted period
might be.
Whether you have to take any insurance services with the mortgage,
and if so whether the insurance must be arranged by the lender or
intermediary.
The costs and fees which might be involved with the mortgage -
valuation fees, arrangement fees, legal fees, early redemption fees
and so on.
Whether you can continue with your selected mortgage terms if you
move house.
When your account details may be passed to credit reference
agencies.
Mortgage interest tax relief (MIRAS) [Now no longer applicable].
Whether you need to pay a high percentage lending fee, and if so what
this means to you.
If you are using the services of a mortgage intermediary to arrange the loan,
they must also tell you if they are receiving a fee from the lender for
introducing the mortgage to the lender. They must also let you know whether
they usually arrange mortgages from a number of selected lenders or from
the market as a whole.
Before your mortgage is completed, your lender or intermediary will confirm,
in writing, the level of service they have provided, and the reasons for any
mortgage recommendation (if they gave you one). Check that you fully
understand this written confirmation, and ask if there is anything that is still
not clear to you at this stage.
The Code's main commitments
The code has 10 main commitments. Broadly speaking, these say that
lenders and intermediaries will:
act fairly and reasonably with you at all times;
make sure that all services and products keep to the conditions of the
Code, even if they have their own terms and conditions;
give you information on services and products in plain language, and
offer help if there is any area which you do not understand;
help you to choose a mortgage to fit your needs, unless you have
already decided on your mortgage;
help you to understand the financial effects of having a mortgage;
help you to understand how your mortgage account works;
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make sure that the procedures staff follow reflect the commitments set
out in the code;
correct errors and handle complaints speedily;
consider cases of financial difficulty and mortgage arrears (missed
payments) sympathetically and positively; and
make sure that all services and products meet the relevant laws and
regulations.
The code goes into more detail on each of these commitments.
Keeping to the code
How the lenders or intermediaries keep to the mortgage code is monitored
independently. And, any organisation under the code must be a member of a
recognised complaints scheme - such as the Banking Ombudsman, the
Building Societies Ombudsman, or the Mortgage Code Arbitration Scheme.
This gives you an extra level of protection, as each of these schemes can
award compensation of up to 100,000 to you if you suffer as a result of your
lender or intermediary failing to keep to the code. Your lender or intermediary
will be able to tell you which scheme applies.
The full mortgage code is also available on the Council of Mortgage Lenders
website www.cml.org.uk.
CAT Standards
In early April of 2000, the Treasury announced a CAT standard for
mortgages. CAT stands for Charges, Access and Terms. It is a voluntary
standard and the objective to set a standard product type which was
supposed to incorporate the most desirable features from the consumers
perspective and includes the following main elements: -
Charges
No arrangements fees or MIG premiums
Interest calculated daily (not the same as compounded daily)
Full credit given for all payments made
No fees paid to brokers
All other fees disclosed
No redemption charges outside a fixed rate period
No redemption charges at all for variable rate mortgage
No redemption charges if you stay with the same lender when you
move home.
Interest (for variable rate loans) to be no higher than 2% above Bank of
England base rate.
Falling rates to take effect within a month of a base rate fall.
Access
Any customer may apply
Minimum loan is 10,000
The lenders normal lending criteria must apply
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You can choose to make repayments on any day of the month
You can make early repayments at any time.
Terms
All advertising and paperwork must be straightforward, fair and clear
You do not have to buy any other product to get a CAT standard
mortgage
If you are in arrears, you still pay normal interest on the debt.
The CAT rules are still in an experimental stage. Ironically, the cost of such
loans may turn out more than for non-CAT loans since offsets are not
possible: in other words commissions on related policies, protection from
mortgage indemnity guarantee (MIG) premiums or discounted interest rates
protected by redemption charges. For example, if a lender cannot charge for
a MIG premium for a high LTV loan, the interest rate must be increased to
compensate.
We must wait and see. But whatever the new rules bring in, the fundamental
principles described herein should remain valid in the long term.
- oOo -
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Annex C
This is a list of the largest 30 mortgage lenders as at mid 2000. Size is not
necessarily a criterion of efficiency, creativity or performance. Many will have
merged by the time you have read this.
Rank Name of Group Year Ended
Mortgage Assets
billion
1 Halifax plc 31-Dec-99 93.0
2 Abbey National 31-Dec-99 64.9
3 Lloyds TSB 31-Dec-99 47.5
4 Nationwide BS 04-Apr-99 36.9
5 Woolwich plc 31-Dec-99 25.5
6 Alliance & Leicester plc 31-Dec-99 19.4
7 Barclays Bank plc 31-Dec-99 18.7
8 National Westminster Bank 31-Dec-99 18.6
9 Bradford & Bingley BS 31-Dec-99 17.1
10 Northern Rock plc 31-Dec-99 15.8
11 Bank of Scotland 29-Feb-00 13.6
12 HSBC Bank plc 31-Dec-99 13.1
13
Bristol & West plc (incl Bank of
Ireland Home Mortgages) 31-Mar-00 12.8
14 Britannia BS 31-Dec-99 9.9
15 Royal Bank of Scotland 30-Sep-99 9.2
16 Yorkshire BS 31-Dec-99 8.1
17 Portman BS 31-Dec-99 4.9
18 Coventry BS 31-Dec-99 4.6
19 National Australia (GB & Ireland) 31-Jan-00 4.4
20 Standard Life Bank Ltd 31-Dec-99 3.8
21 Skipton BS 31-Dec-99 3.7
22 Chelsea BS 31-Dec-99 3.6
23 Leeds & Holbeck BS 31-Dec-99 2.8
24 Derbyshire BS 31-Dec-99 2.3
25 West Bromwich BS 31-Mar-99 1.9
26 First Active Financial plc 31-Dec-99 1.7
27 Cheshire BS 31-Dec-99 1.7
28 Principality BS 31-Dec-99 1.7
29 Norwich & Peterborough BS 31-Dec-99 1.7
30 Newcastle BS 31-Dec-99 1.5
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Annex D
Spreadsheet Summary
The following spreadsheets were included on the original web site (others
may be added later), and are listed here in alphabetical order. They have
been written in both Excel and Lotus 123 format and you should first run the
appropriate compressed self-extracting file from the file. This will
automatically unzip the individual spreadsheets.
Use the spreadsheet menu item View, Zoom to set the screen sizing
appropriate to your computer screen. If you save the unchanged spreadsheet
it will then remember that setting the next time you use it. Most of the sheets
are protected to prevent you accidentally overwriting key formulae, but you
can easily unprotect if you wish, as there is no password.
APR Calculator
A general-purpose APR (Annual Percentage Rate) calculator, illustrating the
use of Goal Seek (or Backsolver in Lotus). It is designed for long term loans
where there may be an interest rate change every year, and some regular or
one-off monthly or annual fees or charges. The Macro button automates the
process.
Buy or Rent
Choose whether to buy or rent a house by entering your own ideas of the
future. An immediate graph indicates when the optimum breakeven point
occurs in terms of how long you stay in the property.
Current Account Mortgage
Choose any combination of payments, credits & debits & graph the results.
Flexible Mortgage
Enter your own mortgage payment schedule and future interest rates: see
some examples of how to use a flexible mortgage.
Flexible Payment Mortgage
The product of the eighties, which included a low-start option and flexible
payments. This sheet is more of historical interest rather than practical value.
Index Linked
The first residential mortgage linked to inflation. As with the flexible payment
mortgage, it is of historical and mathematical interest only.
Investment and Mortgage Calculator
Illustrating the effect of using a savings scheme alongside an interest-only
mortgage, and calculating the optimum savings rate from a given
performance estimate. Includes two examples.
Investment Property Returns
A useful spreadsheet for those interested in buy-to-let or commercial property
as an investment. Estimate the return on capital for almost any scenario.
Determine when it pays to borrow and use gearing to enhance your return.
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Loan Comparator (the basic tool)
Use this to accurately compare any two mortgage or loan products using the
IRR (Internal Rate of Return) method. Calculates APR as well and supports
up to two interest rate changes, illustrating the monthly payments: probably
the most useful spreadsheet of all for serious mortgage seekers.
Mortgage and Loan Product Design
Useful for a lender to help determine the margin required on any loan product.
Then using Goal Seek macros, it will calculate backwards to determine say
the cashback or discount that can be offered to match the required margin.
Mortgage Affordability
A simple spreadsheet to calculate the mortgage advance to match what you
can afford each month and an indication of the income you need.
Mortgage Illustration and Comparator
Ideal for calculating and illustrating the key variables of a mortgage, including
a payment schedule over the life of the loan, and a comparison tool.
Mortgage Scheme Select Wizard
Answer three simple questions to see which type of mortgage scheme suits
you, and an explanation of each scheme.
Mortgage Exposed Part I
A summary of the figures used in the tables in Part I of Mortgages Exposed
in simple, unprotected spreadsheets so that the beginner can get some idea
how the sheets are constructed.
Project IRR
Take any project with monthly cashflows and calculate the IRR
Property Portfolio
A dynamic example of how to build up a portfolio of 16 commercial properties
over twenty years using mortgages and re-invested rental income and, given
initial assumptions, immediately calculate the surprising outcome.
Regional Property Values
Using regional indices since 1973, see how houses have grown region-by-
region, and estimate your own property value.
Remortgage Check
Determine whether it is worthwhile switching to another mortgage scheme by
calculating the potential savings as a lump sum Present Value.
Reverse Mortgages
Illustrating an unusual scheme to compete with home reversions for those
over fifty who are house rich but cash poor.
Rule of 78
Illustrating how to calculate the early settlement of a loan using this method.